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How U.S. REITs May Look Like In Negative Interest Rate Environment - From An International Perspective

by: Roberts Berzins

Currently the FED maintains above-average rates, which are likely to be cut.

Therefore, for any U.S. REIT investor it is important to understand how lower or even negative rates might affect U.S. real estate prices.

EU, particularly Sweden due to a developed and real estate concentrated capital market, serves as a great proxy for what might happen when the rates go down.

Depressed cap-rates, tiny dividend yields and historically high valuations are direct consequences of the negative interest rate environment.

The goal of this article is to give you some color on how U.S. REITs could look like in case FED decides to push the rates into negative trajectory. Since I happen to be quite involved with the analysis of Swedish real estate companies and know the market very well, I will approach this from the perspective of the Swedish property market.

Negative interest rates, highly developed capital markets compared to other EU countries, and a plethora of publicly traded real estate companies make Sweden a great example to have a short look what might lie ahead of us.

As some of you already know, Sweden is considered one of the hottest property markets in the world. Its real estate market has been red hot in recent years, helped by the strong economy and the central bank’s negative interest rates. Residential property prices have risen by about 50% since 2012. They are now, on average, 70% higher than the pre-crisis peak. The scale and intensity of the Swedish property bubble is reflected in the charts below.

Source: Macrobond

The consensus explanation for the sky-high property prices is the extremely accommodative Riksbanken`s (central bank of Sweden) policy stance. Since the financial crisis in 2008, Riksbanken has been very aggressive on cutting rates, bringing down the country's long-term rate lower than Mario Draghi in the Eurozone.

Source: OECD

The chart above reflects the long-term interest government bonds maturing in ten years. The spread between the yields in Sweden and U.S. is rather wide, approximately 2%.

So this should make U.S. REIT investors wonder – how would REITs in the U.S. look like if the FED funds rate went below zero.

Depressed property yields

In the U.S. we consider cap-rates of 6-7% attractive and anything below is taken with a grain of salt. Currently according to CBRE our cap-rates range from 5.5% to 8% depending which sector you are looking at. For more countercyclical property types as multifamily the average cap rate is ~5.5%, while for CBD hotels, which are highly sensitive to developments in the economy, you would find cap-rates at level of 8%.

Source: PwC (Emerging Trends in Real Estate, 2019)

However, the Eurozone property yields have gone down significantly. As a result of interest rates being historically low for a number of years, investors have flocked to higher-income assets such as real estate, with the ensuing compression in yield levels and strong price increases.

Tiny Dividend Yields

In the chart below, I have reflected the current trailing twelve month dividend yield for some of the biggest Swedish real estate companies. It is clearly seen that the offered yields are awfully low. Definitely not the level of current income what you would expect from your REIT investments.

Source: Morningstar (created by the author)

The average dividend yield of the key Swedish real estate players is 1.74%. Since in the U.S. we still have positive rates, yields on our REITs are more attractive. For instance, investing in office REITs on average would net you about 3.77% in dividend yield. From apartment REITs you would capture 3.95%, and by being more contrarian and picking mall REITs you could get a dividend yield of ~10%.

Extreme Valuations

The cheaper you make mortgages — via negative interest rates for banks — the more house prices go up as the supply of buyers enjoying easy cash increases. This axiom captures perfectly the consequences of an accommodative monetary policy.

In Sweden it is not common for real estate companies to reflect FFO and AFFO numbers in their financial reports. So I have used closest alternative what I could get - free cash flows ((FCF)). It excludes non-cash expenses, CapEx and adjusts for changes in working capital.

By comparing the current real estate sector average P/FCF to its historical 5-year norm, we arrive at a ~25% premium. I will not, however, judge whether that is a sign of an overvaluation since you have to take into account both that there is no better domestic alternative and the overall local supply/demand situation.

For example, one of the largest Swedish real estate companies Castellum AB (OTCPK:CWQXF) has gone up by ~20% in each of the past 5 years, while its cash flows have increased by only ~11% on average. Throughout its history it used to provide a dividend yield of ~4%. Now it yield around 2.9%, which is more than a third below the historical norm.

The Bottom Line

One thing is clear - if the FED decides to cut rates, investors who are currently bullish on U.S. REITs will enjoy juicy returns. As the discount rate decreases, property prices take the opposite direction allowing REIT investors to receive a nice capital appreciation.

Nevertheless, in such case the cap-rates and dividend yields would suffer. For a REIT that relies heavily on generating returns from huge acquisitions, the growth prospects would become limited. The same case would apply for any investor, who relies on above-average current income streams from U.S. REITs.

I truly believe that, in the long-run, we will end up having the same level of interest rate as in other major economies. And because of that I keep a considerable part of my portfolio in U.S. REITs. Sweden and other "negative-rate" countries illustrate perfectly how real estate behaves when the rates go down to such extreme levels.

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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. 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.