Tracing credit contagion effects from corporates to the real estate sector

S&P Global Market Intelligence explores possible credit contagion effects from the corporate sector to real estate by using S&P Global Ratings’ research and underlying data to formulate clients’ own views on risks in the sector

The authors

• Michelle Cheong, Head, Credit Solutions Thought Leadership, S&P Global Market Intelligence
• Meredith Beddow, Global head of RatingsDirect^® Market Development, Credit Solutions, S&P Global Market Intelligence
• Clemens Thym, Global head, Credit Solutions, S&P Global Market Intelligence

A tale of two real estate defaults

In July 2021, S&P Global Ratings downgraded the credit ratings for China Evergrande, which eventually went into selective default. China Evergrande’s demise followed the familiar pattern of real estate cycle corrections with an outsized impact on developers aggressively expanding on the back of cheap credit. The credit rating of B- in 2016 provided market participants insight into possible default.
 

 

Michelle Cheong, S&P Global Market Intelligence

In contrast, Washington Prime Group had a BBB- and above credit rating up until 2019 when the Covid-19 pandemic began to cause distress in the retail segment, especially in department stores. S&P Global Ratings research analysts began to flag in 2018 that Washington Prime’s “mid-tier quality mall assets will continue to experience deteriorating operating metrics”. Weaknesses in the company’s corporate customers, coupled with the unexpected outside factor of the pandemic, which accelerated tenant distress, bankruptcies and shop closures, eventually dragged this real estate investment trust into default.

Are there similar cases to China Evergrande and Washington Prime in the real estate sector – and where do we look?

 

Ratings distribution and outlook for real estate looks benign, but the forward-looking credit perspective is murky

S&P Global Ratings currently rates 74% of real estate entities in investment grade at BBB- and above. The credit ratings outlook is anchored around ‘stable’ for this sector. However, with a negative bias of companies with ‘outlook negative’ at 15.6% exceeding ‘outlook positive’ by a ratio of 2.4:1.
 

 

Meredith Beddow, S&P Global Market Intelligence

We are interested in the market perspective and use credit default swap (CDS) indicators to compute an ‘upgrades versus downgrades’ measure comparable to those in figure 2. We map the CDS spreads to a lower-case score from (aaa to d) and compare that to the credit rating. When more (or fewer) entities are mapped higher versus lower than the credit rating, and hence the percentage is positive (or negative), it may be a signal for ratings upgrades (or downgrades) in the sector. You can see that this volatility adjusted measure was mostly negative, with a most recent reading of -13.0%, as the recent slate of news on defaults dampened sentiment. This is in stark contrast to the full sample of corporates, where the same metric is mostly neutral according to the most recent reading at -1.7%, with some signs of recovery from the Covid-19 pandemic in 2021.
 

Identifying the impact of spillovers from corporates to real estate

A key concern is the secondary effects of worsening credit health of the corporate sector, which can spill over to real estate in the form of non-payment of corporate leases. When we look at the credit ratings distribution of corporate entities, we are seeing a peak in the B to B- range, with 18% of these entities rated B- and below at elevated risk of delays or non-payment on their obligations.
 

Weak cashflow to leverage for corporates on the back of elevated interest rates

Looking at the S&P Global Ratings scores for cashflow to leverage for corporates, we note that 23.5% are in the worst two categories on a scale from 1 to 6. In usual circumstances, we would expect a bell-shaped curve on these cashflow-to-leverage scores, with fewer than one-third in the lowest two out of six buckets. In the past two years, we have seen signs of weakness in the consumer sector. But, more recently, we are noticing some weakness in the capital goods corporates with high leverage relative to cashflows.
 

 

Conclusion: implications of risk surveillance on real estate

Clemens Thym, S&P Global Market Intelligence

The current investment grade credit rating of a real estate entity can be seen as a positive sign in that it has at least an adequate capacity to meet its financial commitments (S&P Global Ratings definitions). Negative outlooks – particularly when from both a fundamental and market perspective – and poor financial risk scores may indicate early warnings of deterioration or default. Additionally, continued credit risk surveillance on the real estate company’s corporate tenants can uncover hidden risks, especially in cases where the real estate entity has concentration risks in industries or geographies with elevated leverage. Finally, having the right information is critical. Keeping tabs on analysts’ research updates and context/change in tone of their research reports could provide insights into credit health declines of a specific real estate entity and help formulate downside scenarios in default risk.

_{This analysis has been written and published by S&P Global Market Intelligence, a division independent of S&P Global Ratings, and references in this analysis to “we”, “us” and “our” refer to S&P Global Market Intelligence. This research is differentiated from the credit opinions published by S&P Global Ratings.}

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