Softening fundamentals, recession and weakening liquidity profiles among U.S. equity real estate investment trusts (REITs) spurred Fitch Ratings to lower its outlook for the sector to negative this week. Even so, researchers say REIT performance is in step with the rest of the economy.

With the capital markets frozen, equity REITs face a pervasive vulnerability to credit-rating downgrades, according to Steven Marks, managing director and U.S. REIT group head at Fitch. Forces weighing down on REITs include weakening fundamentals that threaten to reduce property cash flows, reduced liquidity profiles, and pressure to use assets as collateral in order to access debt. “REITs are in a difficult refinancing environment,” Marks says. “In addition, a slowing asset sales market will hamper REITs’ ability to reduce leverage and sell weaker-performing assets to recycle capital to improve overall portfolio quality.”

REITs face the same economic and fundamental challenges confronting the larger commercial real estate industry, Marks says. They may have a unique disadvantage in the credit crunch, however, because REITs must distribute at least 90% of their income to shareholders. “That results in most REITs not being able to retain a meaningful amount of cash.”

Among product types, Fitch changed its outlook from stable to positive for office, industrial and retail REITs, while maintaining a stable outlook for multifamily and health care REITs. Office REITs may face the most severe softening in demand, since space absorption is driven by growth in gross domestic product (GDP) and employment.

Fitch is projecting GDP to contract by more than 1% in 2009, with an unemployment rate of more than 8%. Industrial REITs will have difficulty maintaining rental rates and earnings due to weakened demand and declining national occupancy rates, Fitch states in its report. For retail, economic woes are cutting into consumer discretionary spending, which coupled with a deteriorating labor outlook will increasingly weigh on retail REITs, the report states. An exception will be necessity-based properties such as grocery-anchored shopping centers, which should perform well.

A more positive outlook for apartment REITs reflects their continued access to financing from Fannie Mae and Freddie Mac, while health care REITs will benefit from long-term demographic trends that are driving demand for services amid relatively muted new supply, according to Fitch.

Researchers at other firms don’t dispute Fitch’s expectations for hard times ahead for equity REITs but caution investors against taking alarm at the report. A case in point is the rating agency’s concern over unencumbered asset coverage metrics, which refers to the amount of assets without debt obligations in the portfolio.

An increasing ratio of encumbered assets to debt-free holdings may worry rating agencies and unsecured bond holders but is unlikely to affect an equity investor’s decision of whether to buy a REIT stock, according to Keven Lindemann, director of real estate at SNL Financial, a financial research firm based in Charlottesville, Va. “The equity investor is primarily concerned about overall debt levels,” he says.

REITs are performing much like the larger stock market, says Brad Case, vice president of research and industry information at the National Association of Real Estate Investment Trusts. The FTSE NAREIT All REIT Index shows equity REIT returns are down 44.16% year-to-date compared with the same period a year ago, but the S&P 500 is down 38.13% for the same period. What’s more, the All REIT index showed positive returns as recently as August, with most of its recent tumble occurring in October (down 30.23%) and November (down 21.51%).

Case says the recent drop in REIT stocks has less to do with investors’ perception of declining value and more to do with the volume of shares trading. Case believes a market dynamic called the ‘denominator effect’ caused the bulk of the third quarter’s plunge in REIT stocks. The denominator effect refers to an institutional investor’s reductions in real estate holdings to keep pace with overall portfolio losses.

For example, a pension fund with a diversification strategy to keep 7% to 8% of its capital in real estate must unload some of those properties if its non-real estate investments lose enough value to leave the fund overweighted in real estate. “The easiest way to do that is not selling an office building; it’s selling REIT stocks,” Case says. “That’s probably the biggest reason for the decline in the REIT market in October and November.”

Which REIT stocks are in greatest jeopardy of a ratings downgrade and which will be more attractive to investors? The answers to those questions lie in the individual companies and their balance sheets, researchers say. Those with significant debt coming due for refinancing will have a more difficult year, predicts Jason Lail, senior research analyst at SNL Financial.

Strategies that may have helped in previous years, such as selling some assets to free capital and shore up the balance sheet, will prove challenging at a time when leverage is scarce and transactions are at a near standstill, Lail says. “It’s certainly going to be difficult to sell off those assets that aren’t performing well.”