- Interest rates are likely on the rise.
- How will real estate investment trusts (REITs) fare in this expected rising interest-rate environment?
- For us, the answer is not that straightforward, comprising a number of moving parts both on a fundamental and investment level.
It's official. Interest rates are on the rise, according to new chairman of the Federal Reserve, Janet Yellen. The hike in the Federal Funds rate may be planned for the spring of 2015, the first increase in more than eight years. How will real estate investment trusts (REITs) fare in this expected rising interest-rate environment? The topic has long been debated and studied, and there are myriad opinions on the subject. In our view, the answer is not that straightforward, comprising a number of moving parts both on a fundamental and investment level.
In the valuation context, a rising nominal interest rate (real plus inflation) translates into a higher discount rate applied to future projected net operating income, and by extension, results in a lower intrinsic value (fair value estimate) for any REIT on a universal level, all else equal. REITs are not immune to this law of valuation. However, a rising interest rate environment also signals increased economic stability or strength, which may be beneficial for real rent increases, higher occupancy levels and robust net operating income expansion. These positive factors, in turn, may mitigate the negative impact that a higher discount rate may have on a REIT's intrinsic value altogether. Still, the level of variable-rate debt that a REIT holds will have material implications on its fundamental performance during the coming interest-rate tightening cycle. Moody's outlines this dynamic well:
Lines of credit are the primary source of variable rate debt for most REITs, though some REITs swap fixed-rate debt into floating-rate debt, and have variable-rate mortgages or construction loans. Variable rate debt can be risky for a REIT because of the potential for a rise in interest rates, counterbalanced by the typical fixed level of rent cash flows; the result can become a profit squeeze. Moody's has observed that there has not been a consistent, significant difference between investment grade REITs' and speculative grade REITs' variable-rate debt exposures.
As interest rates increase, investors should also be cognizant that the value of any asset portfolio will become "less affordable" due to the higher interest rate applied in any financing transaction. Higher financing rates, in this case, will negatively impact the net market asset value of a REIT's portfolio from a buyer's standpoint (even if a higher price may be justified via net operating income analysis). Tighter credit markets will restrain the amount of capital available for such assets, and this will have implications on the value of these assets. "Buyer affordability" may be reduced, influencing the level of proceeds garnered under potential asset sales. Likewise, higher rates may reduce a REIT's willingness to pursue projects, if the right price cannot be garnered.
We conclude that the impact of a rising interest rate environment on a REIT's intrinsic value is a function of a) the impact that an increased discount rate will have on the present value of future net operating income, b) the impact that a REIT's pricing power (its ability to drive rate increases) and higher occupancy rates across its portfolio will have on net operating income, c) the quality of its portfolio under a net asset value or liquidation assessment regarding asset sale considerations, and d) the impact of having fewer potential positive economic-value-added opportunities due to higher cost-of-capital hurdles. These variables will each have a different impact on the intrinsic value for each REIT, depending on its balance sheet and property portfolio.
From an investment standpoint, the perspective is slightly different. REITs are widely used as income vehicles, and therefore, their yields are exposed to variations in other income-generating assets, including bonds and other dividend-paying equities. Share prices of REITs and other high-yielding assets should in aggregate be expected to move inversely to interest rates given their bond-like qualities. For example, holders of REITs for income-generating purposes may sell them, driving their respective prices lower, as they purchase other higher-yielding assets (which may have become more attractive as a result of increased rates). The price of a bond is inversely correlated to changes in interest rates, and REITs (via their payout structure) act very similarly to bonds.
The correlation between REIT prices and interest rates, however, is not perfect, and an environment where REIT prices hold up or even do well in the face of rising interest rates is more common than it is not. This is largely due to the fundamental operating enhancements that REITs can generate relative to a fixed payout of a corporate bond or other fixed-income instrument. Research conducted by Cohen & Steers, for example, has shown that rising interest rates and higher inflation do not always lead to poor REIT performance. In fact, they've found that REITs have performed incredibly well in a rising interest rate environment, while serving as an effective hedge against inflation (from Cohen & Steers' observations):
Contrary to a common misconception, rising interest rates do not necessarily lead to poor REIT performance. In fact, REITs have generated an annual return of 12.6% over the six monetary tightening cycles that have occurred since 1979. Over an equal number of periods when U.S. Treasury yields were rising, REITs generated an annual return of 10.8%.
Capitalization rates (cap rates) do not move in tandem with interest rates. In fact, our research shows only a minimal historical linkage between U.S. cap rates and increases to both the federal funds rate and the yields of U.S. Treasury securities. In our view, cap rates and real estate values are far more tied to economic growth expectations and credit spreads relative to U.S. corporate bonds.
U.S. REITs can be effective as a hedge against inflation. U.S. REITs have outperformed stocks and bonds in periods of both rising and moderating inflation. With varying degrees of cyclicality across property sectors-and a long history of dividend growth at a pace faster than that of inflation - U.S. REITs have proven to be, and should continue to be viewed as, an effective inflation hedge.
Although rising interest rates can impact real estate values and the performance of REITs, higher interest rates do not necessarily lead to poor REIT performance. Not only have REITs outperformed stocks and bonds over the long term, but this asset class has generated solid performance in periods when the U.S. Federal Reserve (the Fed) was pushing the federal funds rate higher or U.S. Treasury yields were rising. These trends are illustrated in Exhibits 1a and 1b below. As background, the first of the past six rate hikes in the benchmark U.S. federal funds rate occurred in early 1979, as part of the Fed's initiative to tamp down high inflation. From that point forward through the end of 2012, there were also six periods in which U.S. Treasury yields rose significantly, albeit within some different timeframes.
Image Source: Cohen & Steers
Without a doubt, REITs will be impacted by the rising interest rate environment. However, it is not a foregone conclusion that their price performance will be poor as the Fed begins the next rate tightening cycle in 2015.
We understand that investors have used REITs as a substitute for bonds in their income portfolios, and higher-yielding alternate opportunities brought about by increased interest rates may impact their decisions to keep holding these positions. However, the swap-out of REITs is not guaranteed to transpire, as retaining diversified exposure to REITs in any portfolio is still practical and prudent for many types of investors. Still, it is reasonable to expect some investors to shift out of REITs in coming years (as their individual interest rate thresholds are breached and alternate higher-yielding opportunities are preferred). This is the investment aspect that we outlined above. But from a fundamental standpoint, we don't think the REIT industry will face tremendous operating pressure. In fact, we expect fundamental performance to hold up quite well. We also cannot forget that the market has been expecting the Fed to begin tightening for some time, and unless there are abnormal shocks, REIT investors should be able to count on healthy dividends through the course of the tightening cycle.
All in, we think it may be prudent for investors to reconsider the weighting of REITs in their portfolios. We are comfortable retaining exposure to favorite ideas in the group in the Dividend Growth portfolio, such as the Monthly Dividend Company, Realty Income (NYSE:O), but we're not betting the farm on the industry. At the time of this writing, Realty Income yields 5.4%, while another idea that we have on our watch list, Omega Health (NYSE:OHI), yields 5.9%.
Additional disclosure: O is included in Valuentum's Dividend Growth portfolio, which is inside Valuentum's Dividend Growth Newsletter.