04/29/2014 | By Sarah Borchersen-Keto
As share buybacks are becoming more appealing for equity REITs, ratings firm Fitch Ratings is warning that they pose risks to the companies’ credit ratings.
Despite outperforming the broader market in the first quarter, shares of equity REITs in general continue to trade below net asset value (NAV), making share buybacks “an intriguing use of capital,” according to a report released by Fitch on April 29. As of the end of 2013, REITs traded at a 7.2 percent discount to NAV. In the previous year, pricing was essentially in line with NAV, according to Fitch.
Persistently low capitalization rates are also increasing the appeal of share buybacks, the report said, while improved balance sheets since the recession have made potential share repurchases easier for REITs to rationalize.
The report stressed, however, that current REIT leverage is above levels seen at the end of 2006, just before share buybacks spiked sharply during the last credit cycle. Buybacks leading up to the financial crisis were made at near-peak valuations, and they were one of the drivers of the liquidity issues many REITs faced during the credit crunch from 2008 to 2009, the report added.
“Share repurchases may be a plus for REIT net asset values in the short term, but over time the resultant increase in leverage could impair credit quality,” said Reinor Bazarewski, a director at Fitch, regarding the current buyback prospects.
According to Fitch, data center and multifamily REITs are the most likely candidates to institute share buybacks. Data center REITs traded at an average discount of 12.5 percent to NAV at the end of 2013, and although the discount has moderated since then, it is still the highest in the REIT industry, Fitch noted. Fitch also pointed out that the data center sector carries the lowest leverage among equity REITs.
Multifamily REITs, meanwhile, have continued to trade at a meaningful NAV discount, which Fitch attributed to decelerating same store net operating income growth, elevated new supply in several markets and uncertainty around the ultimate resolution of Fannie Mae and Freddie Mac.
Bazarewski did speculate that REITs’ experiences during the credit crunch may alter their thinking in the most recent market cycle, causing the companies to “maintain greater fiscal responsibility” now.