In a recent edition of the Chilton REIT Outlook, Matt Werner, CFA, Portfolio Manager and Analyst with Chilton Capital Management explains:
Because REITs are viewed as hybrids between equity and debt securities, they are often one of the first sectors to be hit when interest rate fears present themselves. However, history has shown that REIT prices recover after the shock in the first month and, on average, have outperformed the S&P 500 over the following 12 months.
Werner goes out to explain that REITs sometimes are the best performers relative to equities, bonds, and MLPs, and sometimes are not. However, as evidenced below, REITs have had excellent performance in the three most recent rising rate periods (excluding the current period):
Werner argues that it's "shortsighted" to examine REITs and rising rates solely on the dividend yield spread and that investors should examine the effect of interest rates on fundamentals and the potential for increases in the dividend. As he explains:
Historically, the spread between the REIT dividend yield and the 10 year Treasury yield has been about 100 basis points (BPS). Figure 2 (below) demonstrates the relationship between the two, which has been pretty loose. A correlation of 0.6 is not insignificant, but it is certainly not enough to stand alone in a valuation analysis. The most important difference between a public REIT and a bond is the ability for the REIT to increase the dividend. At some points in history, REITs were paying out more than their cash flow in dividends, which made dividend growth unpredictable, at best. At other points, cash flows were growing and payout ratios were low, indicating dividend increases were on the horizon. Analysis of the fundamentals can give analysts and investors higher predictability in the dividend, which may explain why the spread between the dividend yield and the 10 year Treasury yield has not been consistent.
Werner also contends that an increase in interest rates usually implies higher borrowing costs, which would be a negative for earnings growth. However, he argues that "commercial real estate is a capital intensive business, and REITs are paying out over 70% of cash flow as dividends, so debt is an important part of the cost of capital equation."
So as it relates to REIT earnings, the important number to observe is the difference between the coupon on maturing debt and the coupon at which the REIT could issue today to replace that debt. Werner cites "37 REITs that have all originated senior debt offerings issued with an average coupon of 3.9% and an average maturity of 10.4 years (year-to-date)". During this period, Werner says that the "spread on these debt issues over 10 year US Treasury yield averaged 207 bps and as a result, REIT refinancing has been and will continue to be accretive to 2014 earnings until the 10 year US Treasury yield rises to 3.1%, assuming no change in spread."
Another important metric to consider while examining REITs and rising rates is cost of capital. Why? Because REIT capital is made up of a various traunches of capital and every REIT CFO should have a handle on the allocation strategies and cost of capital before deciding to "pull the trigger" on a new investment. As Werner explains:
Currently, REIT balance sheets are made up of 61% equity, 3% preferred equity, and 36% debt. However, REIT private counterparts often use 60% debt and 40% equity (likely a conservative projection). Therefore, the private competitors would experience a disproportionate increase to their cost of capital if the cost of debt increases, all else being equal (we would argue that the cost of equity capital is much higher for private investors). On paper, public REITs would have an advantage in starting development projects or bidding on acquisitions in a rising interest rate environment.
How To Pick the Best REITs in a Rising Interest Rate Environment
As Werner explains, "REITs have been beneficiaries of a 30 year bull market in interest rates that could be coming to an end in the not too distant future as the Federal Reserve begins to taper its stimulus program..(AND) we believe the most important (attribute) of all is growth in FFO/AFFO and dividends."
Investors that are seeking growing dividends as a way to contend with rising rates should find REITs attractive. As illustrated below, the year-over-year growth in REIT dividends from 1987 through 2012 exceeded the rate of inflation in 20 out of 26 years. The compound average rate if REIT dividends was 6.5% over this time period, compared with 2.9% for CPI inflation.
Werner points out that "stock prices do not always correlate with fundamentals; if they did, there would be no technical analysis, and active management via fundamental analysis would be the one and only option for investors." It's clear that REIT results (during a rising rate environment) have close ties to their performance to improving economic conditions and real estate fundamentals. Werner sums up the argument:
Ideally, interest rates will rise gradually as a result of better than expected job growth, thereby providing demand to drive up rental rates and occupancy. In this case, the rise in nominal rates would be due to higher inflation expectations and real interest rates would remain low. However, we cannot plan for the ideal scenario… Despite the risks inherent with investing in a yield-sensitive asset class at close to historic low interest rates, we believe the fundamentals are too good to ignore, which should provide some cushion as rates rise.
Now, Let's Sleep Well at Night by Picking Some Superstars
Warren Buffett learned a lot from his mentor Benjamin Graham however, one thing that Buffett wanted to improve upon was to learn more about the business economics of the so-called "superstars". In order to be successful in that endeavor Buffett studied the financial statements of the companies from the perspective of what made them such long-term investments. As Buffett observed, the "superstar" companies all seemed to benefit from a differentiated competitive advantage that created almost monopoly-like fundamentals.
Buffett has built his success strategy around companies that enjoy competitive advantages (or "wide moats") that could be maintained for a long period of time. In turn, these durable businesses increase in value year after year. Without a doubt, Buffett enjoys instinctive investment acumen as he has explained:
If they become part of your DNA when investing, you really can't go wrong.
However, Buffett must've learned about the "superstars" early in his career as his role model summed up the "buy and hold" secrets. As Ben Graham wrote (in The Intelligent REIT Investor):
One of the most persuasive tests of high-quality is an uninterrupted record of dividend payments going back over many years. We think that a record of continuous dividend payments for the last twenty years or more is an important plus factor in the company's quality rating.
Graham explained further that "the defensive investor must confine himself to the shares of important companies with a long record of profitable operations and in string financial condition".
So whether you're a "defensive" investor (like Graham), a "superstar" investor (like Buffett) or a "sleep well at night" investor (like me), there all the same; you are an intelligent investor. In my Intelligent REIT Investor newsletter, I have hand-picked my favorite "sleep well at night" REITs. These REITs should provide durable long-term performance in periods of rising interest rates. Graham summed up my "sleep well at night" picks as follows:
It is the consistency in the products that creates consistency in a company's profit. Consistency and durability are attributes for competitive advantage.
Here are some of my favorite SWANs:
From the above list of SWANs, I consider these five to be "Superstars" (all with rising dividends):
Source: SNL Financial
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Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended.