The Real Relationship Between REITs and Rising Interest Rates
The U.S. economy has been growing steadily since it rebounded from the financial crisis a decade ago. Recently, the Fed raised short-term interest rates for the third time this year and indicated it will continue to raise rates in 2019, according to the Wall Street Journal.
Major stock indexes plunged as investors fled to less risky assets like bonds and gold, which spooked investors who have grown accustomed to low market volatility in recent years. If this trend continues and investors start to see higher returns from bonds, what does that do to returns for real estate?
The Fed has raised interest rates and investors are asking us if this may lead to lower real estate returns.
The rising interest rate environment raises concern about the potential impact on U.S. commercial real estate property values and investment performance. Real estate investors may fear that rising interest rates may cause capitalization rates to rise and property values to fall, which may result in weaker total returns. This fear may, however, be unfounded.
In fact, broader trends such as an expanding economy, or a strong economic climate in the sector or region where the real estate is located, can sometimes lead to higher performance over the long-term, even as interest rates rise in the short-term.
Higher interest rates do not necessarily result in lower property values and total returns.
Many investors assume that as a rule, interest rates and Real Estate Investment Trusts (REITs) move in opposite directions, where rising interest rates translate to falling returns and weaker performance for REITs. This is a common misconception.
History illustrates that commercial property returns have more often increased than decreased during periods of rising rates. According to NCREIF, in the over 20-plus years between 1996 and 2017, 19 quarters were affected by rising interest rates, all of which resulted in positive commercial property returns.
In the case of a growing economy, like the current U.S. environment, a factor that negates this misconception is real estate demand, which may rise during periods of economic growth. Several other factors determine overall real estate performance, including capitalization rate spreads over the 10-year treasury yield, the outlook for economic growth, real estate market fundamentals, and more.
That said, there are always risks that might affect current economic growth that investors worry about, such as political uncertainty and monetary policy that may lead to volatility in real estate.
Despite a common misconception, interest rates and capitalization rates do not move in lockstep.
This is a chart that NAREIT prepared showing that listed equity REITs performed well, and consistently, during the nearly two decades from 1999 to 2017, specifically during periods of rising interest rates. NAREIT points out that not all this strong performance is the result of these REITs having other funding sources such as the public markets; they attribute much of it to the general tendency of all categories of REITs to perform well even as interest rates increase.
Another factor that may affect total returns is the ability of owners of commercial real estate to raise rents to generate higher returns. For property types where leases are shorter term like multifamily, leases renew more frequently, giving the landlord more opportunities to raise rents than properties with longer-term leases. There is no guarantee that landlords may receive the increased rates from their tenants. However, if rates rise faster than real estate companies can increase rents, there may be some degradation in property value.
If interest rates rise due to an improving economy, however, commercial real estate landlords have the power to raise rents to keep pace with rising rates, and values can potentially strengthen because of higher rents.
Why weakened periods of REIT performance are often only short-term.
On the other hand, evidence shows that increasing rates can weaken REIT performance. Such effects have often proven to be relatively short-term, according to Cohen & Steers. This is because, generally (although not always), the Fed’s decision to increase interest rates reflects the signals it sees of an expanding economy, such as increasing Gross Domestic Product (GDP) for consecutive quarters and low unemployment rates.
For evidence that weakening REIT performance during a rate-hike period is often short-lived, consider this statistic from a Cohen & Steers report : Data measured over the last 20 years show that three months after a change in the Federal Funds Rate, U.S. REITs outperformed stocks by 1.5%. As more time passed, one year after interest rate increased, REITs outperformed stocks by 7.7%. Here is a chart illustrating their research.
Source: Cohen & Steers research report, 2015
In other words, interest rate increases often signal good economic news. Although the rate rises themselves can make borrowing more expensive, they also suggest that the broader economy is healthy and growing, which generally benefits real estate investments because it means businesses are expanding, hiring, and in need of more property for their operations.
If interest rates increase gradually, real estate is likely to be well-positioned to benefit in such an environment.
When an investor purchases a bond, the coupon rate and its maturity date are both fixed, which makes this investment sensitive to interest rate fluctuations. As rates rise, the value of a fixed-rate bond will fall, and vice versa.
A REIT’s value, by contrast, is not fixed. REITs have active managers that invest in real estate. The management team operating a REIT can grow its value and increase investor distributions by growing the REIT’s asset base, increasing rents, adding income-generating services to the properties they own, and other accretive measures.
Real estate investors may experience fluctuating returns in the short-term, but if they focus on the underlying property’s value and stay the course, they may benefit from an investment in real estate in the long-term.
Before investing, consider the “Risks” associated with each investment. Important information about risks, fees and expenses are outlined in the official offering documents. Investing in REIT common shares is speculative and risks include illiquidity, complete loss of capital, limited operating history, conflicts of interest and blind pool risk.