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REITs have greatly benefited from the Federal Reserve's policy of maintaining interest rates at historic lows. The positive effects for REITs have been in (1) dropping cap rates, (2) cheaper financing deals, and (3) an influx of investors seeking stable yields and an alternative to paltry bond returns. As high unemployment subsists and the Fed continues its quantitative easing policy with QE3, REIT prices should continue to climb for the remainder of 2012.

Cap Rates

The Capitalization rate is used to estimate a return on investment. It is calculated by dividing a property's expected net operating income during the next twelve months by its price (= Yearly Income / Total Value). The acceptable ratio (examples: 5%, 6%, etc.) is set by supply and demand - how much purchasers and sellers of property are willing to pay for a dollar of income.

Most buyers will borrow money to finance the purchase of property. Therefore, if interest rates are high then cap rates must be higher so that the purchaser can still receive an acceptable rate of return after paying borrowing costs. If interest rates are low then cap rates can be lower because net operating income does not have to be as high for the investor to receive an acceptable return (Note: This stands true for deals financed though non-debt means. There is always a cost of capital and that cost will be impacted by the cost of borrowing).

When cap rates increase or decrease, "total value" (the denominator of the cap rate equation) will decrease or increase, respectively. Lower interest rates for the foreseeable future are therefore decreasing cap rates, which are resulting in increasing "total value," or net asset values, of REITs.

Borrowing Rates

Borrowing rates have dropped to historical lows. For example, the 30-year mortgage rate is 3.56% and will be further reduced in QE3. Many other borrowing rates will continue to drop as well. According to the Fed's QE3 official statement the federal funds rate will be kept at 0 to 1/4 percent and "anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015." It is important to realize that REITs with investment grade balance sheets can tap into some of the lowest rates while many private real estate operators cannot. Banks want REIT business because of their credit worthiness and typical large deal size. This edge has short- and long-term benefits: (1) REITs are refinancing to lower rates thereby immediately improving their balance sheets and cash flows; and (2) REITs can finance acquisitions and developments at a larger profit spread, which should have lasting positive effects.

Alternative to Bonds

The majority of the world's developed economies are in chronic low-growth mode. A U.S. stock that has expected modest appreciation coupled with above-average dividend yields, which describes many REITs, is in high demand by stock investors. On top of that, REITs are attracting investments that pre-recession would have had been put in bonds.

The 10-year treasury currently trades at a 1.59% yield, which is only slightly higher than July's sub 1.5%, the lowest rate in the history of America. Investors are betting big for the chance of just breaking even with inflation. Take for instance the TIPS issued in late August at a record-low yield to maturity of negative 1.286% over nearly five years. It's not hard to actually lose money in bonds after inflation and taxes. With steady and predictable cash flows and a required 90% payout of taxable income as dividends, REITs are an attractive alternative to bonds and that has no doubt been fueling the REIT sector's market beating growth (For period ending July 31, 2012 - All Equity Reits: 17.4% vs. S&P 500: 11.01% src: NAREIT).

Future

Many quality REITs are seemingly expensive when compared with to the S&P 500, currently trading at about 15.9 X earnings. For example, these are the 5 largest publicly traded REITs:

PriceEstimated Forward 12
Month FFO
P/FFO
SPG$161.60$8.0420.1
AMT$72.81$3.0024.3
PSA$147.58$6.1224.1
HCP$47.00$2.7916.8
VTR$65.07$3.6317.9

Nearly all REITs are trading above a P/FFO of 15.9 (P/FFO is the REIT equivalent of an ordinary stock's P/E), but as interest rates remain low and the sluggish economy persists, demand for REITs should continue to fuel a premium.

The QE3 announcement and Bernanke press conference that followed made clear that ZIRP is here until the structural problems plaguing the U.S. are finally fixed. A CNBC anchor dubbed QE3 - "QE-Infinity" because this is the first ever open-ended Fed expansion with no definite size or time limits. In this distressed economy there are few other investments like REITs that can harness an ultra low interest rate to directly fuel modest growth and premium dividend yields. Of course, when the economy improves and interest rates increase, a lot of money will be taken out of REITs and put into higher growth, cheaper stocks and lower yielding, more stable investments like bonds. Rising interest rates will also result in rising cap rates that will put downward pressure on REIT price-to-book ratios. That being said, low interest rates are helping REITs clean their balance sheets while concurrently developing and acquiring new properties - making REITs well positioned for the long-awaited increasing economic growth.

Credit: The idea for this article came from a Bloomberg interview with Steven Brown, senior portfolio manager at American Century Investments.

Source: QE1 - QE3: Lower Rates Boost REIT Valuations And Demand