By Steve Bergsman
Opinions are split on what impact, if any, a higher rate environment will have on REIT investing
The debate began to heat up earlier this year when the U.S. Federal Reserve first hinted that short-term interest rates would rise. Industry insiders had vastly different opinions on what impact a rate increase would have on the publicly traded REIT industry—especially given the stellar performance and broader investment appeal the industry has earned the last several years during a historically low rate environment.
Every industry has some sensitivity to interest rates, but there seemed
to be a growing perception that REIT stock price performance was more directly linked to rates than stock prices of other industries. Others claimed REITs were no more affected than financial stocks or bonds.
Striking a neutral ground, Lisa Sarajian, a managing director with Standard & Poor's, summed up the debate saying, "there is a yin and yang in the interest rate question; there is always a little good and a little bad with every shift in the wind."
This much is indisputable. The first discussions of a rise in interest rates this year roiled the REIT market. The Morgan Stanley REIT Index (RMS) peaked on April 1 and then fell off a cliff, eventually plummeting 19 percent through May 10.
Through the first quarter, the composite returns on REIT stocks, as reported by the National Association of Real Estate Investment Trusts, climbed a handsome 12.56 percent. However, through May 10, total returns for the composite index fell to -8.04 percent.
Through June 14, the REIT group as a whole charged forward once again, up 11 percent off its lows. At that time, U.S. Federal Reserve Chairman Alan Greenspan gave the clearest hint of the direction of short-term interest rates, saying they were "very likely" to rise gradually, instead of radically, as the fear of inflation moderated.
As June ended, the Federal Reserve pushed up short-term rates to 1.25 percent, a quarter of a point increase, ending a long period of low interest rate stability. The last time the Fed raised rates was in May 2000. Then in August, the Fed once again raised short-term rates by a quarter of a point.
Also on June 14, Steve Sakwa, Merrill Lynch's senior REIT analyst, weighed in with this conclusion about the heretofore 11 percent rise in the RMS: "While the rebound in REITs can be partially attributed to the fact that the stocks were oversold (and due for a bounce), another possible factor contributing to the rebound is the fact that yields on the 10-year Treasury remained relatively stable over the past few weeks."
To which Sakwa adds, "while we are not in the business of forecasting interest rates, we believe that the general direction is up over the next six to 12 months. Hence, we believe it is reasonable to assume the sector could experience further multiple compression if long-term interest rates move higher during the second half of 2004."
Sakwa downgraded 25 REIT stocks that day, and the RMS collapsed 1.75 percent to 582.82, leading one REIT observer to report, this "set the stage for the worst day for the stocks since the RMS plunged 2.3 percent on May 19."
Overall, Sakwa says he is among those who feel a rise in interest rates will negatively affect REIT share prices. His basic contention is that the future performance of REITs will be highly influenced by the direction (and magnitude) of long-term interest rates. This is by no means a majority opinion.
Breaking the Link
On the other side of the argument, some believe that a rise in interest rates may also portend positive developments for REITs because it means the overall economy is doing better. If the economy is healthy and growing, in theory it will help all sectors of real estate as robust firms and the newly employed fill up vacancies.
Many on this side of the argument are quick to point out that the correlation between changes in REIT yields and changes in Treasury yields is very low, approximately 0.03, according to Ibbotson Associates. To which, Deutsche Bank REIT analyst Louis Taylor adds, "there just has not been a consistent pattern of REIT share price performance during periods of rising interest rates."
Additionally, many institutional REIT investors have adopted this view.
Neuberger Berman LLC, the New York investment advisory company that is now part of Lehman Brothers, has been a major investor in REITs over the years and recently undertook a study of the impact of interest rate movement on REIT pricing.
REIT Dividend Yield vs
10-Year Treasury Yields |
 |
| Source: Factset |
"We did a five, 10 and 20-year study and concluded there was no correlation between changes in REIT stock prices and changes in the yield on 10-year Treasuries," says Steven Brown, a Neuberger Berman managing director. "Over the past 20 years, REITs have averaged annual total returns of 12.3 percent—only slightly less than the S&P's average of 13.4 percent."
Neuberger Berman did some further analysis, going back to 1970, and looked for years in which the 10-year Treasury rose. There were 14 such instances, which were then compared to REIT performance during the same periods of time. The result, according to Brown, was that REITs delivered average annual returns of 11.7 percent, surpassing the S&P 500 average return of 10.7 percent.
When asked about the REIT sell-off earlier in the year after the Fed intimated it would raise rates, Brown says, "investors felt that REITs would then perform poorly, but the interesting thing during the sell-off was that no REIT cut its dividend. And REITs have come back. Year-to-date (through July) the S&P is up only 0.02 percent while the NAREIT Equity Index is up 5.86 percent."
Last year, Kensington Investment Group boasted one of the top performing real estate mutual funds, Kensington Strategic (up 31.83 percent). In May, the firm checked in with its own observations on the link between interest rates and real estate securities and it, too, concluded, "changes in REITs' stock prices and other stocks' prices both have historically low correlations to changes in interest rates."
In a recent position paper, Kensington found that, "a modest increase in the benchmark federal funds rate is already priced into the market and thus will have little impact on higher yielding real estate securities. The dynamics that could drive up interest rates, inflationary pressure from economic growth, should also cause real estate fundamentals to improve, which is a positive for all real estate securities and can offset some of the impact of rising rates."
Another top-performing real estate mutual fund was Spirit of America Funds (up 31.84 percent), and Ronald Weiss, portfolio manager, also is not backing off REITs. In fact, he is unabashedly optimistic regardless of interest rate activity and says this is "a tremendous time for REITs."
"REITs, in general, are not really affected by what the Fed does to short-term rates," Weiss says. "When there is uncertainty and when interest rates are going up or down, REITs provide a steady dividend yield. The primary reasons REIT prices were driven down at the beginning of April were because people thought short-term interest rates were going to change, and because money managers with 30 percent to 40 percent returns on the REITs they had invested in over the last year were cashing out on some of those enormous profits."
The Wrath of Con
Don't talk to Mike Kirby, a principal with Green Street Advisors Inc., about REITs not being interest rate sensitive. It's not an argument that holds any weight with him. In fact, he derides the theory.
He charted the course of REIT share prices and the inverse yields on the 10-year Treasury since the secular bull market in bonds began in 1981, and he found the movements of the two were very close to being in unison.
Kirby also looked at two examples of Fed tightening since the beginning of the modern REIT era, February 1994 through May 1995 and July 1999 through July 2000. In both instances as federal funds rates moved up, the NAREIT Equity REIT Price Index dropped.
"Correlations between rates and REITs over the long haul look enticingly low, but this masks the fact the REITs don't do well when interest rates jump upward," according to Kirby. "During April, rates spiked up, and fears arose that a continued upward move was inevitable. REITs performed abysmally. May was a month in which interest rates hit a peak and then began to backslide, assuaging concerns of a big jump in rates. Is it purely coincidental that REITs rallied as interest rates subsided?"
Kirby says REIT prices and interest rates have moved in the opposite direction on 29 of the 41 business days since April 1.
Subscribing to more esoteric measures, Carey Callaghan, REIT analyst at Goldman Sachs & Co., finds himself in the same camp as Kirby.
He suggests investors "yield" to a number of cautions:
- Yield Gap. A relatively constant spread between the average REIT dividend yield and the 10-year Treasury has been maintained. Currently, REIT dividend yields are 80 basis points (bps) above the 10-year Treasury yield, the lowest in five years. If the 10-year Treasury moves up, there is no cushion.
- Yield Curve. With short-term interest rates expected to rise by 200 bps over the next 12 months and the long-end not moving much, the yield curve will flatten. Over the past 15 years, when there have been instances of a flattening yield curve, REITs have underperformed the S&P 500 by about 15 percent on an annualized basis.
Historical Correlation, Volatility and Total Returns
The statistics below are derived from analysis of the monthy total returns of government bonds, preferred stocks,
corporate bonds, REITs and the broader equities market during the period January 1992–March 2004. |
Correlation
Between Government Bonds and: |
| Preferred Stocks 0.55 |
• Interest rates have historically had less of an impact on preferred stocks than corporate bonds. |
| Corporate Bonds 0.96 |
• REITs and stocks both have historically low correlations to interest rates.
|
| NAREIT Composite 0.03 |
|
| S&P 500 -0.05 |
|
Volatility
Standard Deviation of Monthly Returns: |
| Government Bonds 1.73% |
• Preferred stocks and corporate bonds have lower volatility than government bonds. |
| Preferred Stocks 1.11% |
• REITs have exhibited lower volatility than the broader equity market. |
| Corporate Bonds 1.11% |
|
| NAREIT Composite 3.37% |
|
| S&P 500 4.20% |
|
Total Returns
Annualized Total Returns: |
| Government Bonds 7.75% |
• Preferred stocks have outperformed both government and corporate bonds. |
| Preferred Stocks 8.17% |
• REITs have outperformed the broader equity market and have done so with less volatility, higher current dividend yields and low correlation to changes in interest rates. |
| Corporate Bonds 7.33% |
|
| NAREIT Composite 13.32% |
|
| S&P 500 10.60% |
|
|
Source: Kensington Investment Group. Performance of preferred stocks measured by the Merrill Lynch Preferred Index, corporate bonds by the Solomon Brothers Broad Index, and government bonds by the Bloomberg/EFFAS 7–10 Yr. Bond Index, monthly returns for the period January 1992–March 31, 2004. |
Other Arguments
While all these arguments are compelling, there are a number of key points to consider when analyzing the impact of rates on REITs, including the attractiveness of alternative investments, the direct impact on REIT operations, and the behavior of the underlying real estate.
Even if the strength of the link between changes in interest rates and changes in REIT share prices remains debatable, there is little doubt that, when interest rates rise, some other investments become relatively more attractive, and those investors that have rotated into REITs for the yield may reallocate some of their REIT investments into those other sectors, according to Brown.
The moves in the 10-year Treasury have had a direct impact on investment flows to real estate mutual funds, Callaghan says. The flows jumped by as much as $250 million on a four-week moving average basis in the first quarter, Callaghan observes, but reversed by a similar magnitude in April and May at the height of the correction.
Or as David Shulman, Lehman Brothers Inc.'s REIT analyst, says, the urgency to own REITs has diminished. "Now there will be other places to go for income."
Over the past couple of months, investors have abandoned the concept of looking at REIT fundamentals to make their decisions about REIT stocks, says Richard Moore, managing director and REIT analyst with Keybanc Capital Markets.
"Instead they are looking at the yield," Moore says. "Investors are saying if the average yield used to be 150 bps over the Treasury and Treasury goes up 100 bps, then I need my yield to go up 100 bps so I can keep the spread. If I cannot keep the spread, I'm going to sell the REIT and find something that will get me there."
Moore, like Standard & Poor's Sarajian, subscribes to the notion that REITs get the good and the bad when interest rates move.
"The presumption is, interest rates move up because the economy is improving," Moore says. "If the economy is improving, the REIT top line is improving, so there is revenue growth offset by some increase in interest expense. In addition, as interest rates rise, that tends to shut down some of the private buyers and builders. REITs don't have to contend as much with the little
guy who is typically going to finance 90 percent at the margin. The little guys are all debt, so when interest rates go up the cost of their projects go up."
If rates do go up, it will knock some of the leveraged buyers out of the market, confirms Sarajian, and it will put REITs in a better position to make property acquisitions.
While it's too early to tell if this will happen, Fitch Ratings anticipates short and long-term rates will rise 1.5 percentage points in total over the next 12 months. Even taking into consideration a very gradual ramping up, some buyers may quit the market.
Sarajian also sees the yang of interest rates sliding upward. In her view, the downside for some REITs is an exposure to floating-rate debt, which would be quickly affected by interest rate movements. That means the weighted average cost of capital will move higher, and the ability to offset this cost by higher rents may be negligible.
Goldman Sachs charted the most interest rate sensitive publicly traded real estate companies, making note of the impact of a 100 bps increase on funds from operations. The five companies selected as the most likely to be affected were Forest City Enterprises, Inc. (NYSE: FCEA), Apartment Investment & Management Co. (NYSE: AIV), Post Properties, Inc. (NYSE: PPS), General Growth Properties, Inc. (NYSE: GGP) and BRE Properties, Inc. (NYSE: BRE).
It's All About the Real Estate
From a pure real estate point of view, Robert Bach, national director of market analysis for Grubb & Ellis Co., has a few points to make—all of which relate back to the yin and yang of the analyses.
"Owners and sellers will feel some pain, especially those who own older, vacancy-challenged properties financed with floating-rate debt that is not capped, collared or hedged," Bach says. "The prospect for a quick turnaround in leasing activity does not look good (except for retail properties)."
But, Bach also notes, for Class A properties with solid rent rolls in good locations, the story is entirely different. "Investor demand has outstripped supply for the past two years and should continue to do so if the cycle of interest rate tightening remains ‘measured' as the Fed has indicated. Rising interest rates will dampen the ability of many private buyers to bid for Class A properties, but institutional investors may stop in to fill the breach."
A more telling scenario is outlined by Ken Riggs, chief executive of Real Estate Research Corporation. As he notes, low interest rates have been the driving force in the recent pricing boom in real estate—despite struggling market fundamentals. If interest rates move higher, then Riggs says to expect a price decline among all core property types. "As it becomes more apparent that the economic recovery is sustainable, interest rates will increase and this will put commercial real estate values at risk."
Whether REITs suffer or fete now that rates have begun to increase, the only certainty, according to Shulman, "is that the REIT market will have to live with higher than normal volatility in the next several months."
Steve Bergsman is a regular contributor to Portfolio and the author of "Maverick Real Estate Investing."
REITs & Rates