On December 16, 2015, the United States Federal Reserve Board raised interest rates by 25 BPs. It was the first time in nearly eight (8) years that the Fed has acted to increase interest rates. From December 2008 until December 2015, the Fed maintained "ZIRP" or "Zero Interest Rate Policy." That changed on December 16, 2015.
During 2014, the REIT index set lots of new record highs - it was one of the best periods for the REIT industry and it led all other investment indicators. The index itself was up nearly 30%. That success continued slightly into 2015 until - that's right - the Fed began hinting about raising rates and then BOOM! The REIT sector began to cool. Why? If you listen to the "talking heads" that speak on the financial news shows, it's because if rates so go up, REITs will have an increased cost of capital, which could lead to lower profitability. In the absolute, this is true.
The facts point to a different scenario. The only time that higher rates impact a REIT directly is when they either BORROW FUNDS or must REFINANCE existing loans. Period.
Coming out of the Great Recession, many REIT CFOs reshaped their debt profile and capital stack such that no "Maturity Wall" existed. A Maturity Wall exists when a large percentage of the REIT's debt matures at the same time, necessitating a search for either new lenders for maturing debt OR negotiating with the same lender in a rising interest rate environment. Public REITs that encountered debt maturities during the Great Recession faced enormous challenges and an unfriendly lending environment.
The Modern REIT Offers Smooth Debt Maturities with No "Maturity Wall"
As a result of this experience, most REITs now have nominal debt maturities each year and in some years, they have none. In fact, the dollar amount of debt coming due in any one year may be small that debt can be paid off with the REIT's available cash, defusing any concerns that lenders have pulled out of the market or that rates have increased. Some public REITs have taken to issuing public debt as opposed to mortgage debt. The difference is huge.
Mortgage debt typically applies to a single property or a group of properties. Public debt or corporate debt relies on the REIT itself as the borrower versus the buildings themselves. Since a large number of public REITs have demonstrated financial strength by the credit rating agencies (S&P, Moody's and Fitch), the issuance of public debt is now an attractive option. Additionally, it can be structured in such a way to set up the loan in multiple maturities, or tranches, and some of the longest terms can be up to 20 years or more. Another key advantage is that interest rates for many of these REIT debt issues are typically very low - much lower in some cases than comparable mortgage debt.
As a cautionary note, not every REIT is set up to take on public debt regardless of the positives associated with its issuance. The covenants for public debt - those are the requirements of the borrower - which is now the COMPANY versus the property(ies) - can be much different than covenants for mortgage debt. Most REIT CEOs and CFOs are very familiar with mortgage debt from their pre-REIT days, as leverage through the use of mortgage debt played an important role.
However, few of these same professionals know the requirements of publicly issued debt. Terms such as "key man life insurance" and threshold amounts of "inside ownership" of the REITs equity are common with public debt. Just these two factors rarely if ever show up in the covenants for mortgage debt, but they regularly appear in the list of covenants for public debt. The accounting, finance and legal review and ongoing reporting of these covenants may exceed the capabilities of a REIT's in-house professionals. Before even considering issuing public debt, the REIT must determine whether they CAN COMPLY with the proposed covenants.
One example: one covenant requires that the top five REIT executives must own X% of the company's equity. However, they do not. While the public debt issuance is being considered, then action must be taken to increase that insider ownership or negotiate a lower metric with the lender, typically an investment bank acting as a fiduciary. Once this proposed covenant is satisfied, what happens if the REIT decides to issue more shares and raise additional equity for any one of many reasons? Must these same five executives continue acquiring more equity to maintain their percentage level as the base increases? Or will the original amount - i.e.; number of shares - be satisfactory? An additional issue dilutes all existing shareholders numerically including the five top REIT executives. These are issues rarely if ever encountered when borrowing asset based mortgage debt.
Let's face it, rising interest rates will negatively impact the shares of public REITs, period. I can't seem to write enough, discuss enough or teach enough to punch through that concept because it is fundamentally not the case with all REITs especially "Modern REITs."
However, what you can do is analyze the trading activity of certain REITs that, yes, go down in price with the discussion (hinting) of a potential rate increase, and maybe go down in price further, when the Fed does raise rates. However, in many cases, what will happen - and I have been studying this carefully - is that the majority of these same REIT stocks will begin rising again. Their daily trading volume will increase. Why?
In my opinion - again, this is solely my opinion - the professional institutional investors are fully aware of the debt maturity schedules for these REITs. They are ardent students of REIT metrics and when witnessing a softening in the price of a high-quality modern REIT solely due to the discussion of a rate hike or the actual rate hike, these investors know that that one variable, higher interest rates, won't significantly affect that REIT (or the universe of REITs they are focused on). Hence, they still believe these are strong companies from a FUNDAMENTAL ANALYSIS vantage point and yet, from a TECHNICAL PERSPECTIVE, their prices have come down due to the "masses" or "herd" that listen to the financial news shows where virtual unanimity exists that "rising interest rates will hurt the shares of public REITs." Trading in these REITs on the day of these financial news programs (and the days to follow) will show that, yes, the talking heads were right. Many investors may have sold some or all of their REIT stocks anticipating - correctly it seems - a softening in REIT share prices. But if they look a month or so later, they may find that those stocks are back to their prices before these financial news shows stated that the prices would indeed drop.
This is a very important thesis and I hope that you look carefully at the activity of REIT shares and apply it to your own investing technique. Ownership of REIT shares, in my opinion, is meant to be a long-term buy and hold strategy. These companies need time to execute their strategies. Vacant space requires time to lease-up; new developments need time to complete, deliver and lease-up; Planned developments need time to design, rezone, secure myriad permits and much, much more. Real estate is a "boots on the ground" business and incorporates hard assets as their main driver. While the ownership of these companies has been converted to public shares, it is the value of the underlying real estate that gives these stocks the majority of the share price - but not all of it.
Factors outside the hard asset portfolios of REITs weigh heavily on their stock prices - similar to how external factors weigh on fixed income securities, which is the comparison made to REITs by many observers. Why? Because the REIT generally pays a fixed dollar amount dividend. When divided by the stock price, you arrive at the REIT yield. Therefore, it is this component of a REIT where financial news shows reporters draw comparisons to pure fixed income instruments as such as bonds.
Since a public REIT is now valued via their common shares (plus debt) their leadership must be cognizant of the external factors that affect stocks, in addition to managing the portfolio and growing it.
Again, these are points that don't appear when taking a loan out for a single property or a set of them. Issuing debt, which will be sold "to the public", takes on a different level of fiduciary responsibility. The loan is being made based on the entire company - company management plays a huge role in the company's success or failure. To assure the investors who will purchase the REIT debt - these issues are generally sold to institutional investors like insurance companies and pension funds and in some cases, exclusively sold to these investors who are considered very sophisticated "institutional investors" who can fully understand the risk factors of the debt. With rates low and no hard assets as collateral for these loans, a sophisticated lender is an appropriate source of the capital.
In one example, Boston Properties, Inc. (NYSE: BXP - Strong Buy) recently issued $1b in public debt - senior unsecured notes due February 2026 issued at an effective yield of 3.685%, or 155 basis points over comparable U.S. Treasuries.
This is a 10-year note, but some loans can extend out 20+ years. And with the BXP issue's net effective interest rate at 1.55% over the comparable United States debt, this type of loan instrument is very cost efficient. With an overall debt to market capitalization rate of approximately 30% and an interest coverage ratio of well over 3.5/1, it is conservative to say that BXP is well managed from a financial standpoint.
BXP isn't alone. While each REIT requires personal due diligence, this due diligence can be aided by the many research reports from several key REIT analysts in the community. Overall, these companies are fully aware of both the perception of an interest rate increase and the actual rate hike and what effect it will have on company shares. To defend against this, Modern REITs take extraordinary steps to ensure that their loan portfolio is well managed.
Fitch upgraded their view of BXP about six months ago. Their Press Release is here. This was announced PRIOR to their recent $1b senior unsecured note offering. Hence, the ability to issue unsecured "corporate debt" at low rates is further evidence of the company's financial strength.
Rates Up, REITs Down
So getting back to the point - the Federal Reserve talked about the possibility of an interest rate hike - for several months before December's action. Fed Chair Janet Yellen and some of her surrogates began talking about a rate increase as early as June 2015 and the REIT index began to soften. You'll notice a direct linear correlation between these two subjects. Simply put, the "chatter" regarding a potential interest rate increase felled the REIT index, and the actual increase did more damage to it.
However, many public REIT stocks have exhibited a tremendous amount of defensiveness and upside in the face of these actions. So don't be taken in by the perception that rising interest rates will be catastrophic to REIT shares. The softness exhibited by these stocks in the days and weeks that follow the actual rate hike are BUYING OPPORTUNITIES. REITs represent an excellent long-term buy and hold investment strategy. In the meantime, investors receive the benefit of robust dividend income since the REIT industry average annual dividend yield hovers around 3.5% currently.
Next Up - REITs Return
My next several articles will focus on several REITs that I have rated a Strong Buy or Buy. Recently, many of these companies have experienced lower price points, which I believe are technical and not fundamental. Therefore, I feel strongly that this is the time to accumulate shares of these companies for a long-term hold investment strategy. Not only are the prices lower, the going-in dividend yield will be higher as a result. The net result? I will issue several "Strong Buys" on several REITs. In advance of any article, I will advise accumulating shares of both BXP and VNO. Both have a heavy concentration of office buildings in core markets of Washington, D.C. and New York City. Both REITs are well managed and exhibit robust "inside ownership" characteristics. Finally, both companies still have their original founders working and continuing to advise the next generation of company leadership.
Thank you once again for reading this and if you have any questions or comments, please feel free to ask. I will try to respond within 24 hours of your question being posted.
Disclosure: I am/we are long BXP.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.