What Happens to REITs When Interest Rates Rise?

Today we’re diving into a topic that’s crucial for real estate investors: what happens to REITs when interest rates rise. If you’ve been watching the markets, you know that interest rate fluctuations can significantly impact investment performance, and REITs are no exception.

REITs, or Real Estate Investment Trusts, have become popular vehicles for investors seeking exposure to real estate without directly owning property. They offer potential benefits like income through dividends, portfolio diversification, and liquidity. But their relationship with interest rates is complex and important to understand.

In this video, we’ll explore:

• What REITs are and how they work
• The relationship between REITs and interest rates
• Why different types of REITs react differently to rate changes
• Historical performance during rising rate environments
• Strategies for investing in REITs during rising rates
• And what factors beyond interest rates you should consider

Let’s get started!

WHAT ARE REITs?

Before we dive into interest rates, let’s make sure we’re all on the same page about what REITs actually are.

REITs are companies that own, operate, or finance income-producing real estate across various sectors. To qualify as a REIT, a company must distribute at least 90% of its taxable income to shareholders as dividends, which is why REITs often offer attractive yields compared to other investments.

There are three main types of REITs:

1. Equity REITs – Own and manage income-producing real estate
2. Mortgage REITs – Provide financing for real estate by purchasing or originating mortgages and mortgage-backed securities
3. Hybrid REITs – Combine the strategies of both equity and mortgage REITs

REITs can focus on different property sectors like:

• Residential (apartments, single-family homes)
• Commercial (office buildings, shopping centers)
• Healthcare (hospitals, medical offices)
• Industrial (warehouses, distribution centers)
• Hospitality (hotels, resorts)
• Data centers and cell towers
• Self-storage facilities

Each of these sectors has unique characteristics that can influence how they respond to interest rate changes.

THE RELATIONSHIP BETWEEN REITs AND INTEREST RATES

Now, let’s get to our main question: what happens to REITs when interest rates rise?

Conventional wisdom suggests that rising interest rates are bad for REITs, but the reality is more nuanced. There are several mechanisms through which interest rates can affect REITs:

1. Cost of capital effect: Higher rates increase borrowing costs for REITs, potentially squeezing profit margins if they need to refinance existing debt or take on new loans for acquisitions or development.
2. Discount rate effect: Higher interest rates often lead to higher discount rates used by investors to value future cash flows, which can lead to lower REIT valuations.
3. Yield competition effect: As interest rates rise, yields on bonds and other fixed-income investments typically increase as well. This can make REITs less attractive on a relative basis, potentially leading to selling pressure.
4. Economic growth effect: Interest rates often rise during periods of economic expansion, which can lead to higher occupancy rates, rising rents, and increased property values – all positives for REITs.

The interplay of these factors means that the impact of rising rates isn’t straightforward. In fact, historical data shows that REITs don’t always underperform during rate hikes.

HOW DIFFERENT REIT SECTORS RESPOND

Not all REITs respond to rising interest rates in the same way. The impact varies significantly across different property types:

More sensitive to rising rates:

• Mortgage REITs: These are typically the most sensitive to interest rate changes because their business model relies on the spread between their funding costs and the yield on their mortgage investments. When rates rise quickly, this spread can narrow.
• “Bond-like” REITs: REITs with long-term leases, stable cash flows, and limited growth opportunities often behave more like bonds. Examples include healthcare REITs with triple-net leases or office REITs with long-term corporate tenants.

Less sensitive or potentially benefiting from rising rates:

• Short-lease REITs: REITs with shorter lease terms can adapt more quickly to an inflationary environment by raising rents. This includes hotels (daily leases), apartments (usually annual leases), and self-storage facilities.
• Economically sensitive REITs: Industrial, retail, and some office REITs may benefit from the economic growth that often accompanies rising rates, potentially offsetting higher borrowing costs.
• REITs with fixed-rate debt: Companies that have locked in low interest rates through fixed-rate, long-term debt are partially insulated from immediate impacts of rising rates.

HISTORICAL REIT PERFORMANCE DURING RISING RATES

Looking at past rising rate environments provides valuable insights:

From 2004 to 2006, when the Federal Reserve raised rates 17 consecutive times, REITs actually outperformed the broader market. The FTSE NAREIT All Equity REITs Index delivered a cumulative return of approximately 60% during this period, compared to about 15% for the S&P 500.

Similarly, during the 2015-2018 rate hike cycle, many REIT sectors performed reasonably well, especially those benefiting from secular growth trends like data centers and cell towers.

However, during the 2022-2023 rapid rate increase cycle, REITs as a whole underperformed the broader market significantly, with particularly sharp declines in office and mortgage REITs.

What explains these different outcomes? The pace and magnitude of rate increases matter substantially. Gradual rate increases that accompany economic growth tend to be less problematic than rapid, large increases designed to combat inflation.

Additionally, the starting point for interest rates and REIT valuations plays a crucial role in subsequent performance.

STRATEGIES FOR INVESTING IN REITs DURING RISING RATES

If you’re concerned about rising interest rates, consider these strategies for your REIT investments:

1. Focus on quality: Look for REITs with strong balance sheets, low leverage ratios, well-laddered debt maturities, and high interest coverage ratios. These companies are better positioned to weather interest rate increases.
2. Consider REITs with pricing power: Seek out companies that can increase rents quickly in response to inflation. As mentioned earlier, hotels, apartments, and self-storage facilities have this advantage.
3. Look for growth catalysts: REITs with strong growth prospects can potentially overcome the headwinds of rising rates. These might include REITs exposed to secular trends like e-commerce (industrial REITs), data growth (data center REITs), or demographic shifts (healthcare REITs).
4. Evaluate management teams: REITs with experienced management teams that have successfully navigated previous rate-hike cycles may be better positioned to adapt strategies as needed.
5. Pay attention to valuation: During periods of market stress, indiscriminate selling can create opportunities to buy quality REITs at attractive valuations relative to their net asset values and growth prospects.
6. Consider active management: Given the varying impacts across different REIT sectors and individual companies, an actively managed approach might be beneficial during periods of rate volatility.

BEYOND INTEREST RATES: OTHER FACTORS TO CONSIDER

While interest rates are important, they’re just one of many factors that influence REIT performance:

1. Supply and demand fundamentals: Local market conditions, new construction, and demand for specific property types can have a more direct impact on a REIT’s underlying properties than interest rates.
2. Secular trends: Long-term trends like remote work, e-commerce, aging demographics, and technological change can significantly affect different REIT sectors, sometimes overshadowing interest rate impacts.
3. Regulatory changes: Tax policy, zoning laws, and other regulations can materially impact REIT profitability and valuation.
4. Management quality: The skill of the management team in capital allocation, property development, acquisitions, and operations can make a substantial difference in performance.
5. Geographic exposure: REITs concentrated in high-growth markets may outperform regardless of the interest rate environment.

CONCLUSION

To summarize, while rising interest rates can create challenges for REITs, their impact varies widely depending on REIT type, property sector, balance sheet strength, growth prospects, and the broader economic environment.

Rather than making blanket assumptions about how REITs will perform when rates rise, investors should take a nuanced approach, considering the specific characteristics of individual REITs and the particular nature of each rate-hiking cycle.

Thank you for watching! If you found this information helpful, please like and subscribe for more investment insights. Until next time!