- Much of the conventional wisdom on investing is simply wrong. Investors shouldn’t automatically accept such “wisdom” as fact, but ask for the evidence supporting it.
- All information is not “value relevant” information.
- If rising rates reflect strong economic growth, the expected returns to REIT investments might also be good. This could be a reflection of stronger demand or a falling risk premium.
As we have discussed many times, much of the conventional wisdom on investing is simply wrong. For our purposes, we can define conventional wisdom as those ideas that are so commonly accepted that they go unquestioned. Today, we'll look at the idea that rising interest rates would doom returns to real estate investments, specifically the returns from real estate investment trusts (REITs). This assumption - that returns from REITs would indeed tank if interest rates rose - is one I've been hearing a lot about lately as people speculate on the future actions of the Federal Reserve, its bond-buying program and the projections for short- and long-term rates.
As regular readers of my books and blog posts know, the advice I provide isn't based on my personal opinions, or anyone else's for that matter. Instead, it's based on findings from academic research, data and the historical evidence. However, before we dive into the data on interest rates and REIT returns, there's an important point we have to cover. If you have information you think should impact the market - unless it's inside information, on which it's illegal to trade - that information is already embedded in the market's prices. Thus, if the market expects interest rates to rise, the impact from rising rates is already reflected not only in the current yield curve, but in the prices of REITs as well. It's already too late to act on such information, because while it may be important information to have, it's not "value relevant" information. To see evidence of the market's expectation about rising interest rates, just look at the current yield curve - which is steeper than the historical average.
With this understanding about the difference between information and value relevant information, we can now turn to the evidence on the relationship between interest rates and REIT returns.
The Relationship Between REIT Returns and Interest Rates
To see if the conventional wisdom on the relationship between REIT returns and interest rates is correct, we can check the historical correlation of the returns between the Dow Jones U.S. Select REIT Index and five-year Treasury bonds. For the period from January 1978 to December 2013, the monthly correlation of returns was actually a positive 0.07. If we look at annual correlations, for the period from January 1978 through December 2013, the correlation was -0.14. A correlation of close to zero suggests that there's really no basis for the belief in the conventional wisdom that rising rates are bad for REITS.
For another example of how the conventional wisdom associating rising interest rates with poor returns from REITs can be wrong, let's look at some additional historical data. Specifically, let's examine the returns on the Dow Jones U.S. Select REIT Index over the last period of rising interest rates. The Federal Funds (FF) rate bottomed out on June 25, 2003, at 1 percent. Over the next several years, the Federal Reserve kept raising the FF rate until it peaked at 5.25 percent on June 29, 2006. On June 25, 2003, the five-year Treasury note was yielding 2.3 percent. On June 29, 2006, the yield had risen to 5.2 percent. How did REITs perform during this period of sharply rising rates? The Dow Jones U.S. Select REIT Index returned 28.28 percent per annum, providing a total return of 115.55 percent.
If rising rates are supposed to be bad for REITs, why did they produce such great returns? The reason is that the impact of rising rates on REIT returns depends on the source of those rising rates. If rising rates reflect strong economic growth, the expected returns to REIT investments might also be good. This could be a reflection of stronger demand, as well as the likelihood of a falling risk premium, which causes valuations - for example, price-to-earnings ratios - to rise. On the other hand, if interest rates are rising because inflation is growing faster than expected, the markets could become concerned that in order to fight inflation, the Federal Reserve could begin tightening monetary policy. That would put a damper on economic growth, and likely cause a rise in the risk premium, which causes valuations to fall. So we see that there are some periods where rising interest rates are more likely to be good for REITs, and some periods where rising rates are more likely to have a negative impact. And that explains why the correlations have been close to zero over the long term.
The takeaway here, once again, is that just because something is accepted as conventional wisdom doesn't make it correct. Hopefully, the lesson learned is to not simply accept conventional wisdom as fact, but instead to question it and ask for the evidence supporting it.