Interest Rates Can Impact Real Estate Investment Trusts
A key detail to keep in mind when considering investing in REITs, especially today with global interest rates at the lowest level in human history (see below), is that REITs can be highly sensitive to changes in interest rates.
Source: Business Insider
REITs are sensitive to interest rates mainly for two reasons.
First, because of their business model, in which most growth capital comes from debt or equity, higher interest rates means higher borrowing costs. That’s either from taking on new loans, or merely rolling over (i.e. refinancing existing debt). This is why you want to carefully watch your REIT’s balance sheet over time to make sure it’s leverage ratios don’t get too high. Typically the best REITs are run by conservative management teams that avoid overextending themselves when it comes to debt.
Realty Income Corp (NYSE:O) is arguably one of the most conservatively-managed REITs. As seen below, the company has kept its long-term debt to capital ratio stable below 50% (my personal preference for an upper limit) for many years:
Source: Simply Safe Dividends
However, another reason REITs are interest rate sensitive, especially in today’s interest rate environment, is because many investors are yield-starved by low bond rates. Thus, REITs, especially blue chip names such as National Retail Properties Inc. (NYSE:NNN), or Ventas, Inc. (NYSE:VTR), are seen as safe, higher-yielding bond alternatives.
This explains why REITs have done so stunningly well over the past few years, as income investors have bid up their prices due to their generous, secure payments and stellar track record of consistent dividend growth over time. This is a problem that is shared with many of today’s most beloved dividend blue chips such as The Coca-Cola Company (NYSE:KO) and Johnson & Johnson (NYSE:JNJ).
However, the thing to remember is that the Federal Reserve is attempting to normalize rates. This means bringing them closer to their historic average of 5.85% between 1971 and 2016; up from the current rate of 0.5%.
Now don’t get me wrong, I’m not saying that rates will get that high anytime soon, if ever. In fact, as you can see from the Federal Reserve’s own projections below, the Fed’s short-term Fed fund rate, which sets the prime rates that banks charge their most creditworthy customers, isn’t expected to rise above 3.25% even by 2020. And while short-term and long-term rates aren’t precisely correlated, they generally rise and fall together. That means that if rates do rise by 2.75% over the next three years or so, that yields on 10 and 30 year Treasury bond might rise to as high as 4.35%, and 5.1%, respectively.
Source: Bloomberg
Today, high-quality REITs such as W.P. Carey Inc. REIT (NYSE:WPC) and Digital Realty Trust, Inc. (NYSE:DLR) typically yield between 3%, and 5%. If the risk-free rate of return (i.e. Treasury bond yields) rises high enough, then the same group of investors that have piled into REITs over the last few years could reverse course and send share prices much lower. This intuitively makes sense, because any individual stock is naturally much riskier than US Treasuries, even the highest quality “sleep well at night,” or SWAN, REITs.
Thus, investors will demand a risk premium in the form of higher yield to own such stocks, and since yields and share prices are inversely correlated, the rise in yields means a fall in price.
Not just does a potentially falling share price represent a risk that investors need to keep in mind (especially if you will need to sell shares to finance medium-term goals such as retirement living expenses), but share prices can have a direct impact on how quickly a REIT can grow.
Remember that REITs are periodically raising growth capital by selling new shares. So if the share price falls too low, it can become harder to grow because the cost of that capital might get too high. Think of it this way. If a REIT is currently selling at X, and yields 4%, then any new shares it sells also yield 4%, and act as a kind of perpetual bond. Except one that’s dividend will hopefully rises over time, meaning the yield on that particular bit of capital will too.
If the share price then falls to 0.5X, and the yield rises to 8%, then management will need to sell twice as many shares to raise the same funds. This means more dilution to existing investors, and a higher future dividend cost for the company. That will mean that the AFFO payout ratio will rise, dividend security will fall, and future dividend growth might be harder to come by.
In comparison, most c-Corps, such as International Business Machines Corp. (NYSE:IBM) or 3M Co (NYSE:MMM), generate sufficient cash flow to fund their growth internally. They only issue more shares in the form of stock-based compensation to employees or to make large, and hopefully smart, acquisitions.
I’m not trying to say that rising interest rates will necessarily spell doom for the industry, far from it. After all, REITs have been around since 1960 and the industry has managed to thrive under interest rates as high as 21%.
Indeed, REIT.com noted that REITs outperformed the S&P 500 with a total cumulative return of approximately 80% while the Fed raised rates from 2004-2006. S&P also published a study analyzing the impact of rising interest rates on REITs. S&P noted that “when expectations about future interest rates change suddenly, REITs have often experienced high volatility and rapid price changes.”
However, the firm made the following conclusion:
“Ultimately, whether interest rates are rising or falling does not seem to be the key driver of REIT performance over medium- and long-term periods. Rather, the more important dynamics to address are the underlying factors that drive rates higher. If interest rates are rising due to strength in the underlying economy and inflationary activity, stronger REIT fundamentals may very well outweigh any negative impact caused by rising rates.”
Investors need to be careful to buy REITs with experienced management teams, ones that have a proven track record of generating strong shareholder value, and rising dividends, in higher interest rate environments. Short-term price volatility could ensure across the REIT sector if the Fed begins to raise rates more consistently over the coming years, and investors need to be mentally and financially prepared.
