Fourth-quarter 2013 REIT earnings season begins in earnest this week and results should clarify a potential emerging trend in REIT leverage, according to Fitch Ratings.

Leverage increased marginally in sequential quarters during third-quarter 2013 to 6.2x from 6.1x at June 30, 2013 based on Fitch's analysis of the weighted average debt to annualized recurring EBITDA for all publicly traded U.S. equity REITs. This marked the first increase since the sector began reducing leverage during the 2008-2009 global financial crisis (GFC).

Although a development during one quarter does not constitute a trend, there are several reasons to believe that the movement towards lower leverage since the GFC may have reversed.

Development feasibility has improved for several property sectors, most notably industrial and office properties. The reconfiguring of supply chains and strong demand from internet retailers is driving demand for large bulk distribution facilities in a variety of logistics-oriented U.S. markets. Strong tech and energy employment growth is creating office development opportunities in markets such as San Francisco and Houston. Many REITs have taken on additional borrowings to expand the scope of their development activities.

On balance, Fitch views development favorably at this point in the cycle given balanced supply/demand dynamics for most property types in most markets. Moreover, REITs have generally been conservative in their development activities thus far by limiting pipeline sizes to less than 10% of gross assets and the amount of speculative development.

Of greater concern is the possibility that REITs may be taking on additional debt to make acquisition and/or development economics pencil out. Borrowing costs for the sector have increased following the spike in interest rates surrounding the Federal Reserve's taper comments in June 2013. However, acquisition cap rates have been relatively stable, partly reflecting strong demand for core commercial real estate assets by institutional investors that are traditionally less sensitive to changes in interest rates. In addition, REITs trading below net asset value (NAV) are less likely to fund external investments with new equity, in Fitch's view.

Stock buybacks are another reason that leverage could increase. Some REITs have expressed renewed interest in this capital allocation avenue in response to their share prices trading below NAV. All things being equal, Fitch views share repurchases that overwhelmingly favors equity holders as a credit negative.

Additional information is available on www.fitchratings.com.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article, which may include hyperlinks to companies and current ratings, can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.

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Fitch Ratings
Stephen N. Boyd, CFA, +1 212-908-9153
Director - U.S. REITs
One State Plaza
New York, NY 10004
or
Kellie Geressy-Nilsen, +1 212-908-9123
Senior Director
Fitch Wire
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Media Relations, New York
Sandro Scenga, +1 212-908-0278
sandro.scenga@fitchratings.com