By Robin Usson, senior research analyst at Neuberger Berman
With rates normalising, the European real estate sector’s debt sustainability has worsened. Most companies in the sector established their capital structures during the low interest rate environment.
As debt matures and is refinanced at higher rates, unless there is deleveraging, funds from operations (FFO) will be consumed by interest payments, leaving minimal value for equity owners and sometimes insufficient asset coverage for bondholders.
But despite these concerns, S&P continues to rate some highly levered structures as mid-to-high BBB, signalling low credit risk to bondholders. Why?
An overreliance on flawed credit metrics
The European real estate industry has long relied on the Loan-to-Value (LTV) metric to assess a company’s leverage. S&P has its own version of LTV: the Debt-to-Debt-plus-Equity ratio (D/(D+E)). This metric is problematic for three reasons:
- The IFRS leverage illusion – In a low interest rate environment, property valuations soar, artificially boosting the book value of equity, because under IFRS’ Fair Value Accounting, gains or losses on property valuation are recorded as an item in the income statement, which then flows into book value. One can therefore raise more debt (often to remunerate shareholders) while maintaining a stable D/(D+E). As a result, there has been an illusion of stable leverage in the sector even as Net Debt to EBITDA increased by +2x to +4x during the low-rates period.
- Not all equity is created equal – This S&P ratio does not account for capital structure differences, such as minorities or an outsized hybrid capital layer. Minority and hybrid coupon payments ultimately consumes cash flow. S&P generally adjusts for large minority interests by tightening downgrade threshold ratios but is conspicuously not doing so for European real estate issuers.
- Reliance on potentially flawed valuation assumptions – As described above, due to Fair Value Accounting, the D/(D+E) ratio is influenced by valuation assumptions, which can be opportunistic. In our view, cash-flow-based leverage metrics, unaffected by valuations, are therefore superior measures of leverage.
How S&P assesses financial risk for European real estate
S&P uses a corporate criteria framework to provide ratings. It first evaluates Business and Financial Risk Profiles. Modifiers such as diversification, liquidity or management/governance are then added, resulting in a stand-alone credit profile.
For real estate, S&P assesses Financial Risk using three core ratios (Debt/EBITDA, EBITDA/Interest Coverage Ratio (ICR), Fixed-Charge Coverage) and two supplemental ratios (FFO/Debt, and D/(D+E)).
Our analysis indicates that S&P has favoured the supplemental, but flawed, D/(D+E) ratio alongside the core EBITDA ICR to measure leverage in the sector. During the low-rate era, however, the EBITDA ICR underestimated leverage. As interest rates normalize, EBITDA after interest costs (a proxy for FFO) decreases substantially, revealing hidden leverage.
According to S&P’s methodology, the financial risk assessment using the EBITDA ICR metric would shift from “modest” to “aggressive” as the cost of debt increases from an all-in yield of 1.5% to 4.5%. But these warning signs are likely to come too late because S&P still relies on historical over forecasted ICR figures.
Regional and sectoral discrepancies expose typical agency problems
Tracking ratios since 2009 across European and U.S. real estate names reveals regional differences that suggest S&P’s criteria are loosely applied for certain European office-exposed credits. Our analysis reveals:
- Regional application variability – US REITs with “intermediate” Financial Risk have 5x to 9x Debt/EBITDA ratios and 8% to 15% FFO/Debt ratios. European office-exposed REITs with similar “intermediate” Financial Risk have ratios of 12x to 17x and 2% to 4%. This 2% to 4% FFO/Debt ratio is particularly concerning, given limited refinancing to date. We expect some European real estate companies to have negative FFO in the medium term. Unlike the investment grade credit market, which tends to rely more on ratings, European real estate stock prices suggest that equity investors recognise the cash flow leverage predicament.
- Sectoral application variability – Ex-offices, S&P’s financial risk assessment of European real estate names with 10x to 18x Debt/EBITDA ratios and 2% to 6% FFO/Debt ratios is usually “significant” or “aggressive.”
- Criteria loosening post-2021 – Despite higher capital costs leading to increased credit risk, downgrade thresholds have, counterintuitively, become more lenient.
How to better assess financial risk
We recommend using the FFO/Debt ratio. Cashflows remain key in assessing credit risk and debt sustainability, regardless of the sector. We also advocate looking at the composition of a company’s equity, stripping out minority and hybrid capital to assess the real “equity cushion,” which in certain cases is significantly worse than S&P’s D/(D+E) ratio suggests.
We encourage S&P to update its application of the criteria for the European real estate sector to better reflect cashflow leverage, given the structural change in the sector’s cost of capital. Ignoring this misrepresents credit risk and could be masking an agency problem reminiscent of those seen during the global financial crisis. Investors should recognise that credit risk has increased, and debt sustainability has worsened.
Consequently, spreads should not revert to pre-2022 levels relative to benchmarks, as this would fail to account for the heightened credit risk. Relying on S&P current ratings to build a case for mean reversion in spreads appears risky, especially given that spreads were previously supported by a bid from the ECB’s Corporate Sector Purchase Programme.
