Image: REITs have not performed as well as one might have thought. The Vanguard REIT ETF has underperformed the broader market considerably since 2015, while dividends per share have not grown much, if at all, since 2005. Source: Vanguard
By Brian Nelson, CFA
The question on most everyone’s minds: How will equity real estate investment trusts (REITs) fare in the current rising interest-rate environment? The topic has long been debated and studied, and there are myriad opinions on the subject. From where we stand, however, there are two main moving parts consisting of fundamental and investment dynamics that investors should be aware of. Let’s have a look.
Fundamental Considerations
In the discounted cash-flow (enterprise) valuation context, a rising nominal interest rate (real + inflation) translates into a higher discount rate applied to future projected net operating income (NOI), and by extension, results in a lower intrinsic value (fair value estimate) for any REIT on a universal level, all else equal. REITs are not immune to this law of valuation.
However, a rising interest-rate environment could at times signal increased economic resilience, which may be beneficial for real rent increases, higher occupancy levels and robust net operating income expansion. These positive factors, in turn, may mitigate the negative impact that a higher discount rate may have on a REIT’s intrinsic value altogether.
Still, the level of variable-rate debt that a REIT holds may have material implications on its fundamental performance during the current interest-rate tightening cycle. Moody’s outlines this dynamic well:
Lines of credit are the primary source of variable rate debt for most REITs, though some REITs swap fixed-rate debt into floating-rate debt, and have variable-rate mortgages or construction loans. Variable rate debt can be risky for a REIT because of the potential for a rise in interest rates, counterbalanced by the typical fixed level of rent cash flows; the result can become a profit squeeze. Moody’s has observed that there has not been a consistent, significant difference between investment grade REITs’ and speculative grade REITs’ variable-rate debt exposures.
As interest rates increase, investors should also be cognizant that the value of any asset portfolio will become “less affordable” due to the higher interest rate applied in any financing transaction. Higher financing rates, in this case, may negatively impact the net market asset value of a REIT’s portfolio from a buyer’s standpoint (even if NOI remains strong).
Tighter credit markets may restrain the amount of capital available for such assets and could have implications on the value of these assets. In other words, “buyer affordability” may be reduced, influencing the level of proceeds garnered under potential asset sales. When credit is restricted, those that are capital-market dependent on financing are often hurt the most.
The composition of a REIT’s portfolio is perhaps more important during the current interest-rate cycle than anything else. For example, there are significant long-term trends working against office real estate, particularly as employees have grown accustomed to working from home with little loss of productivity. The proliferation of e-commerce on retail exposure and potential changes in healthcare laws could also alter the economics of real estate in these areas.
As uncertainty in the future of real estate continues to be at elevated levels, higher interest rates may also reduce a REIT’s willingness to pursue certain projects if the right price cannot be garnered or if visibility into future operating economics is hindered. It’s reasonable to assume that deals that were being talked about when the 10-year Treasury was near-0% would look far different with the 10-year Treasury now hovering around 3.5%-4%.
On a purely fundamental basis, the impact of a rising interest rate environment on a REIT’s intrinsic value is largely a function of:
- The impact that an increased discount rate will have on the present value of future net operating income,
- The impact that a REIT’s pricing power (its ability to drive rate increases) and higher occupancy rates across its portfolio will have on net operating income,
- The quality of its portfolio under a net asset value or liquidation assessment regarding asset sale considerations, and
- The impact of having fewer potential positive economic-value-added opportunities due to higher cost-of-capital hurdles.
These fundamental variables that arise during an increasing interest-rate environment will have a different impact on the intrinsic value for each REIT depending on its balance sheet and property portfolio. In the current rising interest rate environment, however, because rate hikes have been so abrupt and aggressive, most REIT fair value estimates have been impacted primarily by the first-order effect of an increased discount rate on future net operating income.
Investment (Market-Driven) Considerations
From an investment (market-driven) standpoint, the perspective is slightly different than the fundamental considerations outlined above.
As many know, REITs are widely used as income vehicles, and therefore, their dividend yields are exposed to variations in other income-generating assets, including bonds and other dividend-paying equities. Share prices of REITs and other high-yielding assets should in aggregate be expected to move inversely to interest rates, given what can be considered largely bond-like qualities. What this means is that as interest rates rise, bond prices should generally fall, all else equal.
If interest rates continue to advance, holders of REIT equities for income-generating purposes may seek to sell them, driving REIT share prices lower, as such investors instead purchase other higher-yielding assets (which may have become more attractive as a result of higher interest rates). The price of a bond is inversely correlated to changes in interest rates, and REITs (via their dividend payout structure) generally act very similar to bonds. Over the past 52 weeks, for example, the Vanguard REIT ETF (VNQ) has fallen 23%, while the iShares 20+ Year Treasury Bond ETF (TLT) is down ~19%.
As of the time of this writing, the yield on the 2-year Treasury stands at ~4.2%, while the yield on the Vanguard REIT ETF stands at ~4%. Income investors have a lot to think about when it comes to either holding a basket of REITs with a ~4% yield or 2-year Treasury bills that offer a higher rate. If one can understand why pure income-oriented investors might sell REITs and buy 2-year Treasury bills in this scenario, a move that drives the prices of REITs lower, then you understand the investment dynamic impacting REIT prices.
Valuentum’s Take
Though REITs may fit within a diversified portfolio, as theoretically any asset can, they haven’t delivered in the way many retirees have wanted. As we wrote more recently, the Vanguard REIT ETF paid out $3.561 and $3.254 in annual dividends in 2005 and 2006, respectively, and now 15+ years later, the ETF paid out less than those levels during 2022 ($3.2261).
Not only have REITs, in aggregate, grown their dividends a big “nothingburger” since 2005, but their total return over the past several years (2015-2022) hasn’t been great. Inclusive of dividends received, the VNQ generated a 39.5% total return from 2015-2022, while the S&P 500 (VOO) increased 116.3% over the same time period.
We think it is reasonable to expect investors to shift out of REITs in coming years as their individual interest-rate thresholds are breached and alternate higher-yielding opportunities are preferred. We include a few REITs across the simulated newsletter portfolios, but mostly within the self-storage and tower space–two areas we prefer over office REITs, retail REITs and healthcare REITs.
NOW READ: Why Are the Dividends of REITs So Risky?
The March edition of the High Yield Dividend Newsletter (pdf) >>
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Tickerized for various REITs. A version of this article appeared on our website March 27, 2014.
Brian Nelson owns shares in SPY, SCHG, QQQ, DIA, VOT, BITO, RSP, and IWM. Valuentum owns SPY, SCHG, QQQ, VOO, and DIA. Brian Nelson’s household owns shares in HON, DIS, HAS, NKE, DIA, and RSP. Some of the other securities written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.
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