Weaker Corporate Balance Sheets Could Hurt Tenant Credit in the Near Term
What are we to make of all the noise in financial markets today? The day to day volatility has opened the floodgates on financial headlines that stoke worry about a potential slow down. As we are preparing this blog post, the U.S. Federal Reserve announced that it would reassess the mixed economic signals that we have been talking about for the last twelve-months on our blog [1] [2] [3], and the markets responded in an overwhelmingly positive manner.
None of this news is particularly shocking to anyone in commercial real estate. But the recent economic gyrations may be signaling the end of a prolonged shift in our corporate credit cycle. This could have profound implications on tenant credit for years to come.
After the 2008 financial crisis the Fed effectively cut target rates to zero, down from 5.25%, introducing us to a long period of easy money to stimulate investment and increasing the velocity of money. The Fed’s policies resulted in a structural shift in the types of capital available to companies and led to fundamental changes in corporate balance sheets, leading to broadly weaker credit profiles. We now have a targeted rate of 2.25% to 2.50% and thus the Fed has fewer levers to pull to correct any deterioration in macro conditions than before the financial crisis.
Align this notion with two hard to swallow facts. Corporate credit ratings from Standard and Poor’s and Moody’s have become weaker, while private capital has increasingly been deployed to fund M&A and growth. Both of these truths are driven by the low rate environment we have enjoyed and present a grim outlook for tenant credit in the near term.
Corporate Credit Ratings
According to Standard and Poor’s, the number of global rated companies increased by about 24% since January 2008 (just prior to the global financial crisis), and the majority of the increase (approx. 75%) came from non-investment grade issuances. The Fed’s easy money policies made borrowing cheaper and incentivized borrowing as a means to facilitate funding both consolidation (M&A) and growth. Increased leverage on balance sheets weighs on overall corporate credit quality, and while the past economic conditions supported these leveraged companies, a prolonged weaker cycle could result in significant downgrades and possible defaults.
Private Capital
There has been a significant expansion of private capital on corporate balance sheets since 2008 as well. This comes in many forms, including preferred equity, mezzanine financing, and traditional debt. According to Preqin, a capital markets research company, private equity dry powder has roughly doubled in 2018 to nearly $1.07 trillion from its ten year low in 2012. These funds largely target buyouts and venture capital investments, an area of the economy typically reserved for high risk, low credit quality companies. Investing standards may vary widely among these funds.
What does this mean for Commercial Real Estate Companies
The short answer is that tenant credit is likely to weaken in the near term. The Fed’s position to slow rate increases may be cheered by markets in the short run, but it suggests a future of weaker economic growth. The absence of stable growth prospects means that many of the companies that borrowed in recent years may struggle to meet their debt service obligations, and growth companies that took on preferred equity or mezzanine financing may not meet their growth and profitability milestones. Cost cutting is likely to return, and weaker firms will absolutely look at their space needs as a potential area to trim.
This means we could see more sublets and requests for rent relief in key sectors like start-ups and capital-intensive industries that rely on debt financing (think energy and manufacturing). Office markets like San Francisco, Austin, Seattle, and Houston are particularly exposed to these industries. However, those markets will not be alone. Banks and lenders could see diminished profitability from their loan portfolios and increases in credit losses. Consumer’s would likely scale back on discretionary spending over time, hurting a range of service and retail companies. These factors would almost certainly have a knock-on effect on many of the top office and retail markets in the U.S. by gradually lowering asking rents and absorption.
The best way for landlords to protect themselves is to have a deeper understanding of the credit quality of their tenants as well as structuring dynamic security deposits that limit material downside risk. While the outlook may not be great, TRA can help landlords, investors, and lenders navigate the obstacles that we all face. Reach out to us and learn why we are the most trusted tenant credit consultancy in the market.
