Over the past decade, interest rates fell to historically low levels. This has created a challenging environment for income investors who previously enjoyed healthy, low-risk returns from money market funds, CDs, and Treasury bonds.
In fact, since the darkest days of the financial crisis, many yield-starved investors have been forced to search elsewhere for their income needs, driving up demand for bond alternatives such as REITs.
Let’s take a look at the long-term history of how REITs respond to varying interest rate environments to see which ones, if any, are most likely to continue doing well in the coming years.
Are Higher Interest Rates Bad for REITs?
So from a historical perspective, it is clear that generalizations made about interest rates and REIT performance might be unfair. Rates matter, but predicting the direction of yields and REIT performance is anyone's guess.
There are two reasons why interest rates matter to REITs, and both have to do with the underlying business model of this high-yield industry.
Realty Income (O) has nearly tripled its share count since 2008, for example:
In other words, AFFO per share needs to continue growing in order for the dividends to grow in a sustainable and secure manner.
However, when interest rates rise, bonds, including risk-free Treasury bonds, decline in value, causing their yield to rise.
REITs compete for new capital with bonds, as well as savings accounts, money market funds, and CDs.
Some investors who own REITs today might be inclined to sell their shares if rates rise because they can now achieve similar but less risky yields elsewhere.
To put it another way, because REITs are often seen as bond alternatives, higher interest rates could mean decreased demand for REIT shares, causing a REIT’s yield to rise.
While that’s great for dividend investors looking for new places to put money to work, it can also be a problem for the REIT’s long-term growth prospects.
That’s because the higher a REIT’s valuation (i.e. share price), the less new shares it takes to raise growth capital.
In other words, the less dilution to existing investors is needed in order to continue growing a REIT’s AFFO, and thus its dividend.
Think of it this way. Suppose a REIT currently yields 5%, and management is able to buy new properties at a capitalization rate (annual net income / purchase price) of 7%.
Even if the REIT has to raise 100% of the capital to buy a property by selling new shares, then AFFO per share will still increase, and so will the dividend.
And if the REIT buys the property with a 50/50 mix of equity and debt (with an interest rate of 4%), then the amount that AFFO per share increases is even more due to less dilution and an even lower weighted average cost of capital, or WACC.
However, if interest rates increased to 6% and a REIT’s shares fell enough to raise its dividend yield to 8%, then suddenly the ability to buy that property with 100% equity capital disappears.
In other words, the REIT’s cost of capital has risen high enough to not make the deal accretive.
REITs essentially have an optimal growth sweet spot, in terms of their yield. If shares are too expensive, then the yield is too low for investors to earn the income they need.
But if shares are too cheap for too long (due to higher interest rates, for example), then the REIT gets cut off from growth capital and can’t expand its property portfolio and dividend.
So with the Federal Reserve predicting that interest rates will rise by a meaningful amount over the next few years, are REITs a bad investment idea?
Not necessarily. What it does mean, however, is that you need to stay diversified and be highly selective with which REITs you add to your portfolio.
The Best REITs Can Still Grow Despite Higher Interest Rates
The chart below, courtesy of REIT.com, plots the 12-month return of REITson the y-axis, and the change in the 10-year Treasury yield on the x-axis from 1992 through 2017. The blue dots represent periods when REITs earned a positive total return during each of those periods. The red dots signal that REITs lost money.
While an investment in REITs made money in 87% of rising rate periods observed, it is clear that REITs have been positively and negatively correlated with interest rates during different periods of time, indicating that there are other factors influencing their returns.
Like all other stocks, shares will periodically trade at large premiums and discounts to a REIT’s intrinsic or fair value.
In fact, during the last period of rising interest rates, Realty Income was able to grow its cash flow per share between 4.9% and 9.4% each year.
While higher interest rates make it harder to grow profitably (due to higher costs of capital), higher rates also tend to depress real estate prices. Therefore, a quality management team can acquire new properties for lower prices and thus higher cap rates.
Realty Income's historical results provide a nice example. The company's cap rates have had a strong correlation with interest rates, but the spread between the two has remained fairly constant, providing a steady level of profitability.
For example, at the end of 2017 REIT leverage and interest coverage metrics across the board are much stronger than they were since before the financial crisis.
Not All REITs Are Equally Rate Sensitive
The U.S. News & World Report cited Robert R. Johnson, a member at the Fed Policy Investment Research Group in Virginia, who made several observations about REITs. During rising interest rate environments from 1972 to 2013, Johnson found that equity REITs returned 9.8% annually, but mortgage REITs lose 4.1% per year.
Since the value of a mortgage bond trades inversely to interest rates (higher rates cause mortgage bond values to decline), higher rates will mean that the NAV of a mortgage REIT will decline and often take the share price with it.
Of course, as with most things in finance, mortgage REIT investing isn’t as simple as saying, “Don’t own mortgage REITs if rates are rising.”
If short-term rates rise slowly over time but longer-term rates rise quicker (i.e. the yield curve steepens), then a mortgage REIT’s profitability will actually grow, cash flows will strengthen, and the dividend becomes more secure.
This will attract more investor capital, meaning a rising share price, which will further allow management to keep raising cheap enough equity capital to keep growing.
The best kinds of mortgage REITs to own in a rising rate environment are those that will actually benefit from rising rates.
Mortgage REITs that borrow at fixed rates but lend at mostly floating interest rates include commercial mortgage REITs such as Starwood Property Trust (STWD), Ladder Capital (LADR), Jernigan Capital (JCAP), and Ares Commercial Real Estate Corporation (ACRE).
As a result, residential mortgage REITs are arguably the riskiest kind of REIT to own when rates are rising.
After all, their cash flows are highly tied to the health of the overall economy and their customers being able to continue making their mortgage payments.
During recessions, commercial mortgage REITs can face higher default rates and thus also be forced to cut their dividends.
Interest Rate Sensitivity of Equity REITs
For example, a two-year Treasury will generally decline by about 2% for every 1% increase in interest rates, while a 30-year Treasury would decline by about 30%.
For REITs, the duration that institutional managers are looking at is the length of the contracts that underpin how often the REIT can raise rent prices.
For example, hotel REITs generally own their properties and obtain cash flow from customers’ nightly stays.
Since hotel room prices change on a daily basis, there is very little inflation risk because room rates can be increased each day.
As a result, the hotel REIT interest rate sensitivity we saw above is signaling that this kind of REIT has low interest rate sensitivity because the duration is essentially 1 day.
On the other hand, triple net lease REITs generally sign very long-term rental contracts with tenants, typically between 10 and 20 years.
While these agreements include annual rental escalators to account for inflation, those are generally based on recent inflation rates. In other words, most triple net lease escalators are very low right now, about 1% to 2% a year.
Essentially, you can think of the weighted average duration of a REIT’s rental contracts as the duration of this bond alternative. REITs with longer durations and less flexibility to adjust the cash flow rates they receive from tenants are more sensitive to interest rates.
However, it’s also important to note that, as previously explained, REIT share prices aren’t entirely based on interest rates.
After all, while the last decade has seen many investors treat REITs as bond alternatives, there is still a big difference between risk-free assets (e.g. Treasury bonds) and equity REITs.
All equities are risky in the sense that the dividends aren’t guaranteed.
In fact, triple net lease REITs are generally less volatile than the S&P 500 and lREITs in general (which, as an industry, are less volatile than the market at large).
Why is this? Because the very duration of contracted cash flow that affects the REIT’s “duration” also affects its cash flow, and thus dividend security.
For example, a hotel REIT may have very little interest rate sensitivity because it has a duration of just 1 day.
Think of it like this. If you were an investor primarily focused on dividend safety and income to live off during retirement, would you sell a blue chip corporate bond that paid over 18% and was steadily raising its payout each year faster than inflation just because interest rates increased and the share price declined?
Of course not, because as long as the dividend is secure and growing you are unlikely to have a good reason to sell those shares.
How to Invest in REITs in a Rising Interest Rate Environment
Fortunately, for investors with diversified portfolios (our preference is to invest no more than 25% of a portfolio's value in any sector), the answer is a very simple and adamant “no".
1) Know yourself, your personality, time horizon, goals, and risk tolerance.
2) Make a well-thought-out personalized investing plan that meets your needs.
3) Stick to this plan, never investing based on emotions. Failing to plan your investments is the same as planning to fail at investing.
6) Add on dips (assuming you have new money coming in).
Follow this simple plan and you will be well on your way to reaching your financial goals, whatever kind of dividend growth stocks you invest in.
Higher Interest Rates Present Challenges and Opportunities for REIT Investing
After all, the best quality REITs are led by experienced management teams with plenty of experience growing shareholder value in any kind of interest rate and economic environment.
The key to successful REIT investing is the same as with all dividend growth stocks. Do your research, buy high-quality names at reasonable prices, plan on holding them for the long term, add on dips, and reinvest the dividends.
In the meantime, take advantage of the market’s short to medium-term panics over rising rates to accumulate reasonably priced shares of the best REITs, locking in higher, steadily-growing yields.
While rising interest rates have caused REIT stocks to meaningfully underperform during certain periods of time, it’s also important to remember that higher rates are often a signal of investors’ expectations for stronger economic growth in the future.
At the end of the day, executing a simple investment process, remaining diversified, and staying the course are the best things a REIT investor can do whether interest rates rise or fall from here.