Credit markets generally supportive of REITs
May 6, 2016
During our long tenure covering real estate investment trusts (REITs), our team has often emphasized the influence of credit markets on the trajectory of real estate markets. The cost and availability of credit can spell the difference between a successful real estate project and one that fails to perform, or even gets off the ground in the first place. More broadly, access to credit can be a big determinant of real estate development volume in general — we consider it to be the beating heart that keeps markets in motion.
Back in December 2015 when we were looking ahead to this year, we said that 2016 would be “all about the cost of capital.” Now that the first quarter of 2016 is behind us, it’s a good time to stop and ask: How are credit conditions playing out? We have two observations that we think offer a brief assessment of credit conditions today, as well as some historical context.
- Credit markets are suggesting loudly and clearly that the U.S. economy remains on a very modest growth track. We trace the onset of this sluggishness to the spread widening that started in early 2014. This widening occurred first in the energy sector, then moved to other sectors. Heading into 2015, we saw credit spreads begin to widen in real estate as well. While this certainly raised a red flag with us, real estate credits went on to finish the year among the strongest-performing credit sectors, outpacing high-profile areas like financials and industrials. Today, our takeaway here is that, yes, the economy remains soft and is pulling downward on demand — but we also think that things are different this time.
- Despite warning flags from the credit markets, we think investors should not overlook the fact that real estate fundamentals are reasonably solid. When it comes to supply, for instance, professional analysts (ourselves included) are witnessing noticeably tight conditions. A look at some data helps tell the story: We are currently looking at long-term supply levels, as a percentage of inventory, running at about 1.2%, versus a long-term average of approximately 1.8% (data: Citicorp). This lower supply is in spite of the fact that we are seven years into our current economic recovery.
A possible source of pressure in second-tier markets
If there is any specific corner of the real estate streetscape worth a special look, we think it would be developments in a niche outside the prime, top-tier segment of commercial real estate. So-called “Class B” properties — think suburban office parks and lower-tier shopping malls — could very likely see market values come under pressure due to changes happening within an unsuspecting corner of the credit markets: commercial mortgage-backed securities (CMBS). We think there are structural changes in play for these securities that could ultimately increase the cost of capital for property managers who turn to these instruments to finance their investments.
Part of the transformation has to do with a heightened sense of caution amid CMBS lenders. The recent tumult in global financial markets has made these lenders worry that they will be stuck with low-interest-rate loans that can’t be sold into the market. This has made them leery of writing new loans, which in turn has reduced the supply of financing available to property owners and landlords. We are already seeing evidence of this downtrend, with private-label CMBS issuance for the first quarter of 2016 coming in at a slower pace versus the same period in 2015. Overall, 23 transactions were seen through to completion, amounting to $17.8 billion, versus 32 deals worth $26.3 billion one year ago (data: Commercial Real Estate Direct).
On a year-to-date basis, real estate credit spreads have indeed widened, but real estate issues remain one of the strongest performers in the investment grade space (source: Barclays).
Going forward, this lower volume could create problems for landlords that have maturing debt that needs to be refinanced with new CMBS loans. As loan originators scale back their lending, some landlords may not be able to borrow enough to completely retire their maturing obligations.
To keep things in perspective, we note here that despite the possibility of a slight increase in loan defaults, we don’t think the problems will be nearly as bad as they were during 2007 and 2008, when misjudgments about credit quality, together with weak underwriting standards, created the perfect conditions for a credit crisis. In our view, the real estate landscape is stronger now, with market participants better capitalized on the whole.
Holding a positive outlook, though tempered with defensiveness
With that credit backdrop in mind, we generally expect to see the real estate asset class perform relatively well in the quarters ahead. That said, we remind investors that real estate securities do not trade in a vacuum, and future returns could likely be influenced by performance across other sectors. Corporate earnings at large, for instance, could eventually be a source of pressure on REITs, particularly if they continue their recent trend of delivering disappointing results. (We are very cautious about what lies in store with first-quarter earnings, whose season is getting under way as of this writing.)
We think investors could do well to stay defensively positioned, focusing on real estate companies that maintain strong balance sheets, produce stable cash flows, and have a handle on costs of projects that are in progress or in the pipeline. In this way, we think investors increase the likelihood of benefiting from real estate organizations with the potential to (1) outperform their peers, and (2) capitalize on opportunities that might arise if there is pointed distress in any given area of the market.
The views expressed represent the Manager's assessment of the market environment as of May 2016 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting delawarefunds.com/literature or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.
IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.
Narrowly focused investments may exhibit higher volatility than investments in multiple industry sectors.
REIT investments are subject to many of the risks associated with direct real estate ownership, including changes in economic conditions, credit risk, and interest rate fluctuations.
Commercial mortgage-backed securities are fixed income instruments that are back by a pool of mortgages, specifically mortgages on commercial properties. (Commercial properties come in many varieties; for purposes of this material, the emphasis is on shopping centers.)