How do Interest Rates Affect REITs from an Investor’s Perspective?

So, how do changing interest rates affect REITs? What’s the relationship status? It’s complicated.

A Short Preview…

REIT share prices, like the broader market, often react to changes in the outlook for interest rates, including both the short-term rates set by the Fed and the long-term rates that are governed more by market forces.

Increases in interest rates are often driven by economic growth. This same growth may support the growth of REIT earnings and dividends in the future.

HOWEVER, research is mixed in the relationship between rising rates and REIT performance.

Rising interest rates can certainly be a negative catalyst for high-dividend investments like real estate investment trusts, but that doesn’t mean their stock prices will always go down when rates go up.

Some research studies have shown that REITs returns have generally been positive and have often outperformed the S&P 500 in periods of rising interest rates. While other studies have the opposite.

The Takeaway

Over the long run, gradual interest rate increases are often associated with improvements in macroeconomic conditions.  As economic prospects brighten, rents, vacancy rates and other key operating metrics important to REIT cash flows also tend to improve.  Therefore, interest rate increases may be indirectly associated with increases in REIT earnings, distributions, and subsequently with increases in REIT equity prices.

However, when interest rates spike, REIT prices tend to suffer as investors abandon “interest- rate-sensitive” stocks.  This may be a short-lived phenomenon. REITs may sell off in the early stages of an interest rate rise cycle or in event-driven spikes in rates, but over a full economic cycle it is the fundamentals that drive investment and real estate returns.

Two things are worth noting. 

1.  Interest-rate increases are not necessarily bad for REITs. In fact, when measured over longer periods of time, they have generally been associated with periods of REIT out-performance.
2. REIT sell-offs associated with spikes in interest-rate volatility have often provided active REIT managers with opportunities to add exposure at attractive levels just as fundamentals were improving.

The relationship between REITS and Interest rates is volatile and unstable, but this complex relationship leads to both short-term risk and long-term opportunity.

The Fundamentals of REITS and Interest Rates

Investors often associate REITs with interest-rate risk.  REITs can be negatively affected by interest-rate increases in a similar vein to fixed income investments – as interest rates rise, all else being equal, the income produced by REITs at the current stock price is worth less. Prices generally fall to increase the yield of those stocks relative to other income producing instruments.

However…

For fixed income, the coupon for a bond is fixed at the time of issuance. Thus, as rates rise, the price of the bond must fall.  However, for REITs, the dividend income is not fixed, and may rise with improvements in fundamentals.

Generally, when that 10-year Treasury rate goes up, investors will see REITs go down. The reason is income investors expect a risk premium over what they can get from a risk-free investment. Since dividend yield and stock price have an inverse relationship, rising rates lead to rising dividend yields, which generally lead to lower stock prices. Remember – that’s considering “all things being equal”. And as we know, all things are not always equal.

An Example of Positive Correlation

FTSE Nareit All Equity REIT Index: https://www.ftserussell.com/products/indices/nareit

“The FTSE Nareit US Real Estate Index Series is a comprehensive family of REIT-focused indexes that span the commercial real estate industry, providing market participants with a range of tools to benchmark and analyze exposure to real estate across the US economy at both a broad industry-wide level and on a sector-by-sector basis.”

Over longer periods, there has generally been a positive association between periods of rising interest rates and REIT returns; rising rates generally reflect improvement in the underlying fundamentals.

Market interest rates typically increase during periods when macroeconomic conditions are strengthening. REIT investment performance is also driven by the same type of underlying growth. Strengthening macroeconomic conditions typically lead to higher occupancy, stronger rent growth, increased funds from operations (FFO) and net operating income (NOI), rising property values and higher dividend payouts.

The figure below illustrates the relationship between the four-quarter change in the 10-year yield and the four-quarter total return on the FTSE Nareit All Equity REIT Index. REITs posted positive total returns in 84% of months with rising Treasury yields over the period Q1 1993 to Q2 2021.

Why REITS May Continue to Perform in a Rising Rate Environment

REITs have strengthened their balance sheets and are poised to continue delivering earnings growth in the event of rising rates. REITs have maintained lower leverage rates since recovering from the Financial Crisis of 2008.

Debt-to-book assets was at 50.3% at the end of the first quarter in 2021. However, economic recovery has raised market values. Leverage ratios are returning to pre-pandemic levels and debt-to-market assets was at 32.8% by first quarter end.

REIT earnings have the potential to remain strong as deleveraging means that interest expense has declined. Interest expense was 21.6% of NOI in the first quarter of 2021. Down from 25.7% at the peak of the pandemic.

Most of the borrowings of REITS are at fixed-rate. Meaning that rising rates are not likely to increase interest expense as much, as if the borrowings were floating-rate. Additionally, REITS have extended average maturities to over 87 months, locking in these low interest rates.

References
https://www.reit.com/investing/reits-and-interest-rates

Examples of Weak and Negative Correlation

MSCI US REIT Index (RMZ)

“The Index is a free float-adjusted market capitalization index that is comprised of equity REITs, including large, mid and small caps securities. It represents about 99% of the US REIT universe and securities that are classified in the Equity REITs Industry (under the Real Estate sector) according to the Global Industry Classification Standard (GICS). The Index excludes Mortgage REIT and selected Specialized REITs.”

Below is a linear regression model using monthly data over the past 10 years between 10-year Treasury and the MSCI US REIT Index (RMZ). It shows very little evidence of a relationship between the prices of REITs and changes in interest rates.  Here the correlation of REITs to Treasury Futures is only -0.07 indicating a weak relationship. And the regression statistics indicate that even this weak relationship is not statistically significant (R-Squared of 0.005, T-statistic less than 1). 

From this analysis in isolation, one could conclude that there is a weak long-term relationship between interest rates and REITs.

However, if we examine how the relationship between interest rates and REITs evolves over shorter time frames, a more complex picture emerges.  The chart below shows correlations over rolling 60-day periods of the RMZ Index with changes in 10-year U.S. Treasury yields.  Correlation, measured between -1 and +1, is a measure of how two return series move relative to one another.  A positive correlation means there is a direct relationship, while a negative correlation indicates they move in opposite directions.

There are periods where REITs and rates moves are positively correlated. There are also periods where the correlation is negative.  Over the five-year period, the correlation averages out to -0.1, indicating a weak, slightly negative relationship.  We can see in the chart that, not only does the correlation shift at times. But the magnitude also becomes quite significant.

The times of high negative correlation tend to happen when interest-rate volatility is high. What’s also important to understand is that each of these periods where interest-rate volatility spiked coincided with a sharp rise in interest rates.

Here is the 12-month chart of the RMZ MSCI US REIT Index.

References
https://www.forbes.com/sites/greatspeculations/2017/07/10/reits-have-complicated-relationship-status-with-interest-rates/?sh=bceca1362603

The Outlook

It is likely that interest rates will continue moving higher in the coming months. Therefore, it’s important to remember why interest rates are rising, in the context of what drives REIT valuations. The U.S. is in a reflationary stage of economic expansion, marked by solid corporate earnings growth. The negative factors generally associated with rising nominal interest rates may be largely offset by these positive trends. Additionally real estate markets continue to show low levels of new supply in many U.S. markets. Not all REIT sectors carry the same degree of interest-rate sensitivity.

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