I have long thought about the impact of rising rates on various parts of the market and in particular on REITs. My conclusion has always been that REITs are no more sensitive to rising rates than the broader market.
On Monday, 9/26/22, the ten-year Treasury yield rose to around 3.9%, sending REITs down around 3% intraday. The other major indexes were only down about 1% at the same time in the middle of the trading day.
The market says I’m wrong.
I don’t listen to market price to draw conclusions about fundamentals. I firmly believe that fundamentals determine market price and not the other way around. However, when the market delivers such a unanimous verdict that contradicts the fundamentals, it’s worth taking the time to re-measure and see if I was wrong. In this effort, I will examine the prevailing theories on why REITs might go for a chin in a rising interest rate environment.
I made an honest attempt to look at each theory with an open mind. We’ll cover each theory in detail and show how we arrived at our conclusions.
Theory #1: REITs are heavily leveraged, which will become more expensive as rates rise
Theory #2: REIT debt will get more expensive, driving down earnings
Theory #3: REITs are owned by those seeking income and therefore losing some of that customer base as other fixed income assets become more viable
Each of these theories is discussed among finance professionals and frequently discussed in the financial media. I personally witnessed all 3 chats on CNBC, which is widely regarded as a respectable source of financial news. Thus, I will give due respect to the potential merits of these arguments, including those with which I disagree.
Theory #1: REITs Have High Leverage – Invalid Due to Factual Error
REITs have debt, but the term high debt would indicate that their leverage is high relative to something else, which would presumably be the broader market.
This is factually incorrect.
There are 11 GICS sectors. 5 of them have higher debt to equity than real estate, and the other 5 have less debt to equity than real estate.
REITs are roughly in the middle of the pack in terms of absolute levels of leverage.
Looking at debt charges versus earnings, REITs are also at a fairly normal level. Data from Yardeni shows that S&P’s interest expense was about 22% of net income in 2017. It was significantly higher in previous years when interest rates were higher.
I couldn’t find the same stat for the REIT index, but looking at individual REITs, it’s roughly consistent.
Largest REIT, American Tower (AMT) recorded $277 million in interest expense in 2Q22 and $1.649 billion in FFO (earnings), equating to approximately 16.8% interest expense as a percentage of earnings . AMT’s debt to equity ratio is 28%, which is slightly lower than the REIT average, so one would expect the average REIT debt burden to be slightly higher than AMT’s. .
WP Carey (WPC) has an average level of leverage and in 2Q22 had interest expense of 18.2% as a share of FFO.
Small cap REITs are probably going to be a bit higher, just like the Russell 2000 would be a bit higher.
Given the similar magnitude of debt and debt-related expenses, this should not cause REITs to underperform in a rising rate environment.
What about the nature of the debt?
Theory #2: Rising Debt Costs Will Hurt REITs – Disagree, as Offset by Higher Revenues
Sometimes I feel like the market sees debt as the sword of Damocles, ready to crash at any moment or, in this case, raise interest charges.
The problem with debt is that it is incurred to buy assets or generate business. Looking at debt in isolation, rising rates are of course a bad thing because debt is getting expensive, but the most realistic attribute to look at is the comparison between income streams and expense streams.
So yes, REIT debt will become more expensive, but the assets associated with that debt will also generate more income. You see, the higher the interest rates, the harder it is for potential tenants to buy a property. Now that mortgage rates are in the 6%+ range, homes are less affordable, keeping more people in the rental market. So apartments can charge more rent.
The same is true in other sectors. Tenants don’t want to buy their own malls, data centers, towers, etc., so they lease. Rental rates are positively correlated with interest rates and in this case the correlation is causal in nature.
As higher rental income offsets higher interest charges, the question becomes one of duration in a bond sense. For those unfamiliar, duration is essentially a measure of how far into the future a bond’s weighted average remaining cash flow will be.
Extrapolating this to the company level, a company with an asset duration longer than the liability duration will be penalized by rising rates, while a company with an asset duration shorter than the duration of liabilities will generally be helped by rising rates.
In this regard, REITs and the S&P have done a good job of ending their debt and locking it in at fixed rates.
As of August 2022, the weighted average term to maturity of REIT debt was 87 months and nearly 90% of REIT debt is fixed rate.
This gives quite a large window for the income side of the equation to come into play. Real estate itself is a very long-term asset, with well-maintained buildings lasting centuries in some cases and at least 40 years. for just about every type of real estate. domain. This long asset life is often confused with REITs having long-lived assets.
The term of a REIT’s income is not the life of the asset, but rather the current term of the lease. Over the next 7 years, before REIT debt has a chance to increase, REITs will be able to reset the majority of their earnings at the now significantly higher market rate.
REITs are a low duration asset with longer duration debt. This is good for a rising rate environment in terms of bottom line.
Theory #3: Capital Flows Will Hurt REITs – Largely True and Probably the Reason REITs Have Fallen So Much
There are significant differences between the REIT and S&P investor bases.
For starters, 80% of S&P is held by institutions, while REITs are closer to 60%.
Note that in both cases, institutional ownership counts ETFs even if the ultimate owners of those ETFs are at least partially retail investors. So the number for both is significantly lower, but even after adjusting REITs still have significantly more retail investors.
Retail investors are the most educated they have ever been in the market, but they still don’t quite have the level of knowledge and experience that institutional investors have. As such, they are more likely to buy or sell for non-fundamental reasons. This could potentially explain why REITs have more volatility both upside and downside, despite REITs’ underlying cash flows being slightly more stable than the S&P.
Another big difference in the investor base is that a large portion of REIT investors are income investors. Given that REITs have a significantly higher dividend yield at 3.77% compared to the S&P at 1.69%, this makes sense as an income vehicle.
However, it also means that REITs compete more directly with bonds for the portion of investors who primarily seek investment income. So, as bonds become more attractive due to rising rates, this could lead to capital flows from REITs into bonds.
I suspect it already is.
Investors of course have a variety of risk tolerance levels. When interest rates were close to zero, even some of the most risk averse were likely forced out of their comfort zones as Treasuries provided negative real returns. Many likely ended up in REITs as a substitute for higher-yielding bonds, given the predictable nature of cash flows.
In 2022, as rates soared, this trend likely reversed. On 9/22/22, approximately $60 million exited the Vanguard Real Estate ETF (VNQ)
Data for 9/26/22 is not yet available, but I suspect it’s even worse.
I have summarized the 3 main theories as to why REITs are suffering in this environment in a chart.
REITs are highly leveraged
REIT debt levels are in line with the broader market
Rising rates will hurt REIT earnings
Interest charges will be offset by higher rental income, which comes into effect sooner than debts decrease their fixed rates
Capital flows out of REITs due to bond-like composition
This makes rational sense, and there is preliminary data showing ETF REIT outflows.
how i play it
Fully acknowledging that fund flows could drive another downside, I think it’s worth emphasizing that fund flows are not a fundamental factor.
In other words, the market may continue to sell REITs if rates continue to rise, but rising rates don’t actually hurt the earning power of REITs. As such, fundamental strength could cause REITs to rebound strongly from the artificially depressed level. I’m not smart enough to time the bottom, so I won’t try.
Prices are well below fundamentals and the outlook for rental rates remains solid, so I remain fully invested in REITs.