Co-produced by The Belgian Dentist for The Income Strategist
REITs are often considered to be a bond proxy, and that’s why many REIT investors pay close attention to interest rates. Paying close attention to interest rates makes sense for bond investors because interest rates are the primary driver of total returns on fixed-income investments.
However, REITs are not bonds, something often overlooked by "pure" income investors. In an improving economy, landlords can raise rents as tenants fight for more space, potentially increasing cash flows to offset the effects of higher rates. When the economy is stronger, people demand more office, industrial space and hotel rooms. This tends to lead to higher occupancy rates and stronger rent growth. That’s good news for real estate investors.
In other words, it should matter why rates are rising, not simply that rates are rising. Rising Treasury yields have been historically positive for REITs when accompanied by a stronger economy. Currently the American economy is doing fine. Not great, but fine. The probability that the Fed kills the economy by tightening too much seems almost non existent. The probability of rampant inflation also seems to be highly unlikely. All this bodes well for REIT investors.
Interest rate sensitivity
As we said, REIT share prices generally rise as interest rates increase during periods of strong economic growth. The positive relationship is because a more robust economy boosts REIT earnings and the value of the buildings they own, while interest rates rise due to the demand for credit (and possibly inflation). The relationship tends to turn negative, however, when the Fed is (over)tightening monetary policy, because this often slows the economy, which has a negative impact on earnings.
Currently the correlation between interest rates and REIT prices is positive.
Exhibit 1: Correlation between REIT Total Returns and 10-year Treasury Yields
While the relationship was positive for much of 2016, a period when Fed monetary policy was widely viewed as being on hold, the negative relationship returned around the time that the Fed began raising interest rates.
The period of negative responses is significant because it contributed to REIT underperformance relative to the S&P 500 and other broad market aggregates during the past few years. That’s why the Fed’s comments that their target for short-term interest rates will remain around current levels, and the return to a positive relationship between REITs and interest rates, is favorable for REIT investors.
Performance after previous tightening cycles
So, REITs have the ability (and the history of) increasing their asset base as well as raising their distributions to investors even when interest rates are on the rise.
Exhibit 2 shows the return of stocks and REITs for three periods before and after a Fed tightening cycle. The exhibit clearly shows that while stock and REIT returns are both subdued in the three months immediately before and after a Federal Funds Rate tightening cycle, the performance of REITs picks up significantly after six months and even more significantly after 12 months.
Exhibit 2: Returns for three periods before and after a Fed tightening cycle
Given the fact that the Fed has ended its tightening, the outlook for REITs looks fine.
When we look at James Picerno’s Recession Probability Estimate, we can conclude that a recession is not around the corner.
Exhibit 3: Recession Probability Estimate
And what about the inverted yield curve?
Economist Campbell Harvey is credited with discovering the predictive power of yield curve inversions in his 1986 PhD dissertation. He found that an inverted yield curve was bad news for the economy, foreshadowing a recession.
He looked at two parts of the yield curve, the five-year note minus the three-month bill, and the 10-year bond minus the three-month bill. The crucial thing is to use a very short-term interest rate.
So when the 10-year bond minus the two-year note inverts this is of no importance.
Campbell Harvey stressed in a recent interview that the for the inversion to be meaningful, it needs to last for at least a quarter. If it's a day, so what? GDP is measured quarterly, so we need to measure this quarterly also.
So while a portion of the yield curve briefly inverted recently, it quickly steepened again and didn't even stay inverted for more than a day. So we can only conclude again that a recession is not around the corner – at least not based on the predictiveness of the yield curve.
In fact, the US economy performed rather well in the first quarter, with a growth of 3.2%. President Donald Trump cheered the economy’s performance. “This is far above expectations or projections,” Trump tweeted.
This followed a 2.2% growth rate in the fourth quarter 2018. Economists polled by Reuters had forecast GDP increasing at a 2.0% rate in the first three months of the year. If the US economy continues to grow through July – very likely – it will mark 10 years of expansion - the longest on record.
Growth in consumer spending, however, which accounts for more than two-thirds of U.S. economic activity, slowed to a 1.2% rate from the fourth quarter’s 2.5% rate. The moderation in spending reflected a decline in motor vehicle purchases and other goods, likely related to a 35-day shutdown of the federal government. There also was a slowdown in spending on services. The government said the shutdown had subtracted three-tenths of a percentage point from GDP last quarter. However, retail sales have since rebounded strongly, pointing to some acceleration in consumption in the second quarter.
All in all we can say the American economy is doing fine.
Interest rate expectations
So, what are the expectations for interest rates? For short-term interest rates we can be… short. We expect the Fed to keep them steady for the remainder of this year.
What will happen to long-term rates? Normally, long rates rise when the Fed starts raising short-term rates. This pattern was evident in the monetary tightening cycles that occurred in the early and late 1990s. This familiar pattern seemed to break down, however, during the tightening cycle that occurred in the mid-2000s. In that episode, short-term rates continued to rise along with the Fed’s policy rate, but longer-term rates hardly moved at all. The episode is commonly referred to as the“Greenspan conundrum,” since then-Fed Chairman Alan Greenspan openly mused about the puzzling behavior exhibited by short- and long-term interest rates at the time.
What will happen next? Will long-term rates again start climbing higher, or will they remain at their current low level?
Let’s divide the question into three parts:
Real rates, inflation expectations and the term premium.
First, real rates. The expectations of future short-term real interest rates are a fundamental determinant of long-term yields. Long-run expectations are determined and anchored by the equilibrium real interest rate, or r-star. This is the inflation-adjusted, short-term interest rate that's consistent with the full use of economic resources and steady inflation near the central bank’s target level. Standard economic models imply that r-star is linked to households’ degree of patience, which influences their willingness to save, and to the expected growth rate of potential GDP, which influences the rate of return from saving. Current r-star-estimates hover around 0.8%.
Exhibit 4: Real interest rates and economic growth
The historical statistical relationship between potential GDP growth and r-star can be used to construct a 10-year projection for the natural rate of interest. The CBO’s projection of a gradual rise in potential growth over the next 10 years implies a gradual rise in r-star to a value around 1%.
Exhibit 5: Natural rate of interest
There are several reasons why one can expect economic growth to be limited in the coming years and hence r star will not rise much. The two most important reasons are the rising government debt and disappearing tailwind of declining unemployment figures.
Much of the real GDP growth we’ve observed since the global financial crisis has been driven by a cyclical decline in the rate of unemployment, while the underlying “structural” drivers – labor force growth and productivity growth – have continued their sustained slowdown from historical norms. The chart below shows this breakdown, where actual GDP growth is shown in blue, the contribution of unemployment fluctuations is shown in green, and underlying “structural” GDP growth is shown in red. Holding the U.S. unemployment rate constant, trend U.S. real GDP growth would currently be running at just 1.6% annually.
Exhibit 6: Contribution of unemployment figures to economic growth
Another reason for limited expected economic growth are the high government debt levels.
Federal debt accelerations ultimately lead to lower, not higher, interest rates. Debt-funded traditional fiscal stimulus is extremely fleeting when debt levels are already inordinately high. Thus, additional and large deficits provide only transitory gains in economic activity, which are quickly followed by weaker business conditions and slower economic growth.
On the other hand if president Trump succeeds in forcing the Fed to lower interest rates, this could give a boost to the US economy.
So, all in all, we expect real rates to climb slowly to 1%.
Second, we look at long-term inflation expectations. What matters are expectations over the entire 10 years, hence understanding the role of this expectations component requires a long-run perspective. Interestingly, long-term inflation expectations in surveys have remain firmly anchored at the Fed’s long-run inflation target of 2%, as noted in e.g. the Survey of Professional Forecasters. Overall, there's no survey evidence that suggests any meaningful downward shift in the inflation expectations underlying long-term yields.
Exhibit 7: Survey of Professional Forecasters Inflation Expectations
Our final building block is the term premium, which captures all factors other than expectations of future inflation and real short-term rates. The term premium is the compensation investors require for holding a long-term bond compared to rolling over a series of short-term bonds with lower maturity. In that sense, interest rates are driven by investors’ expected average level of the risk-free rate and a compensation for the longer holding period.
The term premium includes the inflation risk premium as well as any effects of changes in supply and demand that are unrelated to expectations, such as safe-haven demand for Treasuries. New York Fed economists Tobias Adrian, Richard Crump, and Emanuel Moench (or "ACM") present Treasury term premium estimates from 1961 to the present.
Exhibit 8: ACM term premium
Currently the term premium is negative.
The biggest factor pushing down the term premium seems to be the inflation risk premium. An explanation that reconciles the stable survey inflation expectations with the decline in nominal yields is that the inflation risk premium has fallen. This risk premium compensates investors for the uncertainty about future bond returns due to changes in inflation. When investors become increasingly worried about low inflation, this pushes the inflation risk premium into negative territory. Investors are paying a higher price for nominal bonds because they value them as a hedge against low inflation.
Currently investors are neither worried by higher nor lower inflation. The Fed publishes option market-based estimates of the probabilities of rising or declining inflation expectations.
Exhibit 8: Option market based inflation probabilities
In the last months of last year there was a large drop in the probability of rising inflation and at the same time a large increase in the probability of falling inflation. In other words, the inflation risk premium fell. This resulted in a lower term premium and hence lower long-term interest rates. At the beginning of May both probabilities are rather low, implying that market participants expect inflation to be rather stable.
To summarize, we expect real rates to increase very slowly the coming years, and inflation expectations to remain anchored around current levels. The biggest swing factor will be the inflation risk premium. All-in-all, we don’t expect a sharp increase in long term interest rates in the near future.
The ideal backdrop for REITs looks like this: A well-performing economy that leads to both higher profits for REITs and rising interest rates. In these circumstances there's a positive correlation between interest rates and REIT returns.
The current environment for REITs is pretty close to this ideal backdrop. Economic growth is maybe a bit lower than would be ideal, but we actually cannot complain.
This means there's no need for REIT shareholders to rush to sell all their REIT holdings at once out of fear for sharply rising interest rates. Not that any "pure" income investors would ever even consider selling.
This also means there's no need for REIT shareholders to tilt their portfolio away from rising interest rate sensitive REIT sectors like triple net lease, student housing and healthcare.
We suggest remaining well diversified across REIT sectors by buying (or continuing to hold) diversified ETFs like the iShares U.S. Real Estate ETF (IYR) or the Vanguard Real Estate ETF (VNQ). Those ETFs are of course tilted toward the bigger names, or, consider the Invesco S&P 500 Equal Weight Real Estate ETF (EWRE) which has an equal weight across all 32 holdings and therefore has higher exposure to smaller-cap REITs.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Business relationship disclosure: This article was written in collaboration with The Belgian Dentist
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