Trumped-Up Trickle Down REIT-Onomics: Do Interest Rates Matter?

|
Includes: MORL, MORT, REM, WPC
by: Wayne Hylarides

Summary

Interest rates don’t typically affect overall REIT performance.

CAP rates aren’t really correlated to interest rate fluctuations.

Individual REIT performance is still subject to interest rate risks.

Read the risk section in the annual report to evaluate each REIT individually before investing.

In the Trump era of tax reductions and economic growth, we need to consider how this might affect our portfolio. We all know that the Fed is raising interest rates as signs of economic prosperity float through the air, but how will it affect REITs? Interest rates in the US and Canada remain quite low and have been for seven years. But rising rates have some real estate investors worried. A common theory is that rising interest rates will weaken property values and commercial real estate performance. Although at the macro level there may not be significant correlation, at the individual REIT level I believe you should evaluate specific interest rate risk to determine if they match your risk profile.

Real Estate Returns vs. Interest Rates

Historical data shows that higher interest rates are not necessarily correlated to real estate returns. Here is an analysis performed by TIAA Global Asset Management:

Note that even in the nightmare condition of the early 80's, real estate performance was great in spite of extremely high rates. This graph is more indicative of a correlation to the overall economy than pure interest rates, i.e. the early 90's and the financial crisis. TIAA's analysis found that even if you account for the lagging effect, no significant correlation between interest rates and returns can be found.

Why isn't there a correlation?

On average, there is a 300 basis point spread between bond yields and CAP rates. This spread acts as a buffer allowing real estate investors time to adjust rents to account for increasing interest costs. In addition, fixed mortgages hedge against short term fluctuations. Rising interest rates are also associated with economic prosperity, leading to an increased demand for commercial and residential real estate.

Another misconception is that doubling interest rates doubles the cash flow cost of debt, but it only affect the interest portion not the principal payback portion. For example, a 25 year $1M mortgage at 3% costs $4,742.11 a month, where as doubling the interest to 6% changes the mortgage cost to $6,443.01 or a 36% increase (still significant, but not double).

What about CAP rates?

CAP rates or capitalization are how individual commercial real estate properties are priced. They are essentially the net income yield based on what investors are willing to pay for a property. TIAA wrote another report titled "Cap rates rising: Fear and loathing in real estate". In it they analyzed the historic CAP rate transactions versus the 10 year Treasury yield:

Although there is a moderate correlation (0.6), they found "no statistically significant effect of Treasury rate changes on cap rates" and found several situations where the inverse situation occurred. So don't think that just because a straight line was placed through a bunch of data points there is statistical correlation.

When you think about it, if interest rates go up the net operating income will go down as a result of increased interest costs. Therefore, it would be a double whammy to valuations if CAP rates significantly adjusted in tune. It's not that simple. There are too many other factors such as foreign investors, economic conditions, and real estate perceived risks that affect CAP rates.

Do CAP rates affect REIT Valuations?

If you own a real estate property, low CAP rates increases the value of real estate, while high CAP rate devalues. In theory, changes in CAP rates can affect the overall valuation of a REIT's assets. But since I value REITs purely based on their cash flows and the risk to those cash flows, CAP rates don't change my valuation. I focus on the underlying economics and property management abilities that affect specific cash flows of owned assets.

Consider the effect of CAP rates on new property acquisitions. Churn of capital within a REIT is important to cash flow growth. In reality, when CAP rates go up, REITs lose money when they sell, but make new acquisitions at a discount (higher yield). If CAP rates go down, they make money when they sell, but pay more to acquire new properties (lower yield). In general, CAP rates vary by specific location risks and property use type. For example, here are the 2015 generalized CAP rates for Toronto, as reported by Colliers International:

Another consideration is that "CAP rate exits" are less important to returns than the compounding effect of increasing the net operating income has. In this graph TIAA showed that after holding a property for 10 years, the exit CAP rate isn't as significant.

Specific Risks

Interest rates can affect every REIT differently. It's best to read the risk portion of the annual report to get started. I suggest you evaluate the following:

  1. The debt load of the REIT. Although some investors say the rule of thumb is 50% LTV, that is not always the case. In fact, if you are a private real estate investor, often 75-80% LTV is the norm. LTV affects cash flows, can increase risk, but can increase returns. Risk mitigation strategies and the overall economics of the cash flows factor in here.

  2. AFFO Buffer. If a REIT has a high LTV, they may be investing in properties with high yields that offer significantly higher cash flow. Therefore, the higher mortgage costs may be offset by the large yield, leading to maintainable cash flow. Note that higher yield can be associated with higher tenant risk or cash flow volatility, but not always. In addition, the REIT could be sufficiently diversified to handle the risk.

  3. Interest rate hedging. How has the REIT hedged against interest rate risk?

    • Have they converted to fixed rate mortgages?

    • Do they buy credit swaps?

    • Do they accept interest rate risks and float on variable rate mortgages?

    • Have they spread out their mortgages redemption dates?

    • How is interest on their bonds calculated (fixed or variable)?

  4. Foreign interest rate risk. Is the REIT exposed to foreign interest rate fluctuations?

People often don't take the time to read the annual report, but I suggest you at least skim through the risk section to start your analysis. For example, here are some of the risks W.P. Carey, Inc. (NYSE: WPC) highlighted in their annual report related to debt:

  • Because we invest in properties located outside the United States, we are exposed to additional risks such as changes in relative interest rates and the availability, cost, and terms of mortgage funds resulting from varying national economic policies.

  • Our level of indebtedness and the limitations imposed on us by our debt agreements could have significant adverse consequences.

  • Our consolidated indebtedness as of December 31, 2016 was approximately $4.4 billion, representing a leverage ratio (total debt less cash to EBITDA) of approximately 5.9.

  • We may be at a disadvantage compared to our competitors with comparatively less indebtedness.

  • As of December 31, 2016, we had $1.7 billion of secured consolidated indebtedness outstanding. The effective subordination of our Senior Unsecured Notes, or other similar debt securities that we issue, may limit our ability to meet all of our debt service obligations. The market price of our Senior Unsecured Notes may be volatile.

In this case, without even knowing much about WPC operations you can quickly determine if this REIT fits your risk profile, hopefully saving you time and effort.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.