Finance: Rising interest rates won’t kill REITs

PHUKET: Many investors looking for yields and exposure to real estate have piled into Real Estate Income Trusts (REITs) despite the prevailing investment wisdom being any eventual rise in interest rates will be a disaster for the sector. After all, REITs rely heavily on borrowing to acquire real estate with interest payments on this debt usually being their biggest expense.

However, before you consider dumping your REITs when interest rates eventually rise, consider the following reasons not to:

Historical Performance

Using historical data, Deutsche Bank published research earlier this year that showed while REIT performance is interest rate sensitive, they only underperformed stocks by a small margin over periods when interest rates rose. In the period afterwards, they actually tended to outperform the broader markets.

Tempting Dividends

REITs typically pay out all of their taxable income as dividends. Given the low yields on other investments, some investors have gone so far as to substitute REITs for bond investments with this substitution proving to be a shrewd [albeit risky] move since the end of the financial crisis. This could be a problem should these investors have a knee-jerk reaction and dump their REITs when interest rates do rise.

Biggest Risks

Rising interest rates are not the biggest risk for REITs. Actually, the biggest risks come with recessions when vacancy rates rise and occupancy rates along with property values fall. Likewise, any decrease in credit quality at any point in time can prevent weaker REITs from refinancing their debts or force them to pay higher interest rates with this hitting the bottom line or their ability to maintain strong dividend payouts to investors.

Debt Refinancing

Normally, only a small portion [perhaps 10 per cent] of a REIT’s debt needs to be refinanced in any given year. In fact, REITs will most likely save on interest payments when they refinance since most of the expiring debts are still above the cost of new financing.

Stronger Underlying Businesses

Interest rates should only rise if it is clear the economy is growing on a sustained basis with a good economy ultimately leading to more operating income and higher occupancy rates, rents and property values. Moreover, any rise in interest expense in an improving economy is a good excuse to raise rents on tenants in order to offset any increase in interest payments.

Privatization Trends

Large investors like sovereign wealth funds and pension funds have noticed that REITs offer a much more favorable yield than anything available in the bond market. That has led to a number of REITs being acquired or moved private by such investors.

Commercial Property Exposure

REITs are the primary and easiest way for retail investors to gain exposure to a commercial property recovery. And while many Americans remain “underwater” on their home mortgages as values are still below their pre-financial crisis peak, commercial real estate values and rents for non-retail properties in the US have largely improved with office vacancies declining and industrial properties benefiting from strong demand for warehouse space. In addition, multifamily housing vacancies are near historic lows as rents continue to rise in many parts of the country.

International Real Estate Exposure

More than 30 countries around the world have adopted REIT legislation largely modeled on US legislation. This means international investors can look for REITs in other real estate markets [including both developed and emerging markets] where interest rates may not be set to rise just yet.

It is still unclear when interest rates will begin to rise in most developed economies and what impact any rise will have on the overall economy and especially on real estate.

What is clear is that rising interest rates will lead to more volatility of REITs and more risk for investors as weaker players or those in certain real estate niches could be hit harder than stronger players. For those reasons, you and your investment advisor will want to take a much closer look at any individual REITs in your portfolio along with any funds that might hold them or other real estate related investments.

Don Freeman,BSME is president of Freeman Capital Management, a Registered Investment Advisor with the US Securities Exchange Commission (SEC), based in Phuket. He has over 15 years of experience working with expatriates, specializing in portfolio management, US tax preparation, financial planning and UK pension transfers. Call for a free portfolio review. Don can be reached at 089-970-5795 or email: freemancapital@gmail.com.