The impact of rising interest rates on REITs (real estate investment trusts) has emerged as a popular and efficient way for market participants to access real estate assets.
Strong long-term returns and other key investment characteristics, such as liquidity, high dividend yields, increasing diversification and hedging against inflation, have contributed to the appeal of REITs. Today, however, there is growing concern about how REITs will perform as interest rates rise.
It is commonly asserted that REITs are destined to underperform when interest rates rise. However, an examination of the historical record suggests that this is a misconception. Although interest rates certainly affect real estate values and, therefore, the performance of REITs, rising interest rates do not necessarily lead to poor returns.
What does historical data tell us about the impact of rising rates on REITs?
Since 1975, there have been six periods where the U.S. 10-year bond yield has risen significantly. In four of these periods, REITs have generated positive returns and in three of those periods, REITs have outperformed stocks. In only two of those periods did REITs generate negative returns and underperform equities.
One of the best ways to compare REIT performance during changes to the 10-year treasury yield is to use the performance of the treasury yield with a REIT index, such as the FTSE Nareit U.S. Real Estate Index Series. This index tracks the performance of the U.S. REIT industry at both an industry-wide level and on a sector-by-sector basis.
Historically, REITs have performed well during periods of rising long-term interest rates. The average 12-month return during periods of rising rates reached 16.5%, compared to 10.7% in non-rising rate periods, spanning from the last quarter of 1992 through the fourth quarter of 2021.
Index performance helps measure the impact of rising rates on REITs
Another very popular performance indicator is the Vanguard Real Estate ETF (ticker: VNQ). This ETF is the runaway leader in the sector with $47 billion in net assets. Its portfolio of nearly 170 holdings spans all manner of properties from warehouses to malls to hospitals.
VNQ has increased its dividend yield by over 50% in the past year. This surge in return accompanied increased treasury yields.
While a Fed tightening cycle due to inflation creates additional uncertainty about whether the correlation between REIT returns and long-interest rates will remain positive, it is noteworthy that REITs have historically outperformed during periods of above average inflation.
What is the impact of rising rates on REITs?
Undoubtedly, rising interest rates pose challenges for REITs. All else being equal, high interest rates tend to decrease the value of properties and increase REIT borrowing costs.
In addition, higher interest rates make the relatively high-dividend yield generated by REITs less attractive when compared with lower-risk, fixed-income securities. Thus, higher interest rates make the relatively high-dividend yield of REITs less appealing to income-seeking investors.
What is the outlook when interest rates rise?
It is clear that rising interest rates are associated with factors that positively affect REIT fundamentals. For instance, in inflationary periods, real estate owners typically can increase rents. As a result, REIT dividend growth historically has exceeded the rate of inflation.
As mentioned earlier, high interest rates tend to decrease the value of properties. But it is important to remember that interest rates do not directly correlate with home prices. Instead, low rates stoke home buyer demand. In turn, higher demand leads to increased sales prices.
However, under the current conditions of supply and labor shortages, it is not anticipated that the housing pricing will come down. Instead, housing prices won’t keep growing exponentially as in the past.
The impact of rising rates on REITs typically shows long-term correlation
For income stocks like REITs, their yields generally move in tandem with risk-free rates. As treasury yields rise, investors expect the risk premium to rise as well. As REIT yields rise amid rising rates, yields and share prices tend to have an inverse relationship.
REIT share prices, like the broader stock market, have been sensitive to changes in the outlook for interest rates. Those include both the short-term rates set by the Federal Reserve and the long-term rates that are governed more by market forces.
In the current inflationary environment, the Federal Reserve has signaled it will be increasing short-term rates. While REIT prices may react in the short-term to changes in the outlook for interest rates, there is typically a positive correlation between rising rates and REIT returns over long periods.
Adam Johnson is an editorial intern who writes for www.stockinvestor.com and www.dividendinvestor.com.
