Higher interest rates are on the horizon as the U.S. economy recovers from the global pandemic. As a result, it's worth investigating how higher interest rates affect REIT performance. REITs have done phenomenally well over the past 20+ years. However, interest rates could be going up post pandemic.
A Real Estate Investment Trust (REIT) is a great way to diversify your investment portfolio. Stock prices are high and valuations are close to all-time highs. Buying a REIT also attractive if you don't want to manage physical real estate yourself. I've been a landlord for a couple properties since 2005, and it can sometimes be a real hassle.
In 2017, I finally sold one investment property for 30X annual gross rent, and reinvested $550,000 of the proceeds in real estate crowdfunding to simplify life.
This post will address a common misconception that rising interest rates are bad for REITs and all property.
Higher Interest Rates Is A Positive Signal
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, looks to be unfounded if we look at how REITs have performed in a rising interest rate environment in the past.
One reason interest rates rise is due to higher appetite for riskier assets during a strong economic climate. For example, investors sell bonds, causing interest rates to risk, because they want to buy stocks that may provide a higher return.
Another reason interest rates rise is because inflationary pressure is expected to rise due to a strong economy. With a tight labor market, wages tend to increase. With higher labor input costs, product prices tend to increase and so forth. With the Fed's desire to keep inflation at roughly 2%, they will raise the Fed Funds rate to try and reduce inflationary pressure.
Higher Interest Rates And Property Values
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.
It would seem that growing demand for real estate in a strong economy more than offsets the negative effects of higher borrowing costs. 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.
Relationship Between Interest Rates And REIT Total Returns
Take a look at this chart that shows REIT performance versus interest rates. As you can see, REIT performance is upward sloping as interest rates rates.
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.
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.
REIT Performance When The Federal Reserve Starts Hiking
Of course, REITs can and do underperform under an interest rate change regime. REITs can also underperform if the Fed signals a much more aggressive interest rate hiking outlook versus expectations.
But based on history, underperformance tends 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.
Gradual Interest Rate Increases Tends To Be The Best Case Scenario For REIT Performance
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. However, 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. REIT performance has generally been strong over the years.
Just one thing to not for those who dislike volatility. Back during the March 2020 stock market meltdown, many publicly-traded REITs actually ended up declining even more than stocks. As a result, if you want to dampen your portfolios volatility, you should consider investing in private eREITs from Fundrise or individual commercial property deals.
REIT Alternatives For More Stability
Check out CrowdStreet, my favorite real estate marketplace for accredited investors. CrowdStreet is based in Portland and connects accredited investors with a broad range of debt and equity commercial real estate investments.
CrowdStreet is attractive because they focus primarily on 18-hour cities. These secondary cities tend to have lower valuations, higher net rental yields, and potentially higher growth.
If you are a non-accredited investor, Fundrise is my favorite real estate platform due to its various funds and eREITs. Fundrise is a great way to invest in regions across America and in different styles. For most people, investing in a diversified fund is probably the best way to go for real estate exposure.
Personally, I've invested $810,000 in real estate crowdfunding to diversify away from San Francisco real estate. As a father of two young children, I also want to earn income as passively as possible. Investing in private real estate is 100% passive and less volatile. Private REIT performance has been solid since real estate syndication deals really took off in 2012.
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