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Assessing the Impact of Rising Rates on REITs

Conventional wisdom suggests that higher interest-rate environments are typically a negative for real estate investment trusts (REITs) — but a close look at historical data paints a more complicated picture.

Yes, historically REITs have performed poorly during the initial stages of a rising-rate period, but they often have rebounded as the rate increases are known and accounted for by the market. In fact, REITs have had positive performance in 87 percent of rising-rate periods, and outperformed the S&P 500 in 53 percent of rising-rate periods.

While we haven’t had to recover from 0 percent rates before, REITs have already rebounded from early-year selloffs, rising 10 percent in the second quarter to post slight gains so far year to date. And this positive performance may continue given historical trends.

Historical Patterns

REITs must pay out at least 90 percent of their taxable income as dividends, and as a higher-yielding investment they can be expected to exhibit sensitivity to interest-rate changes. It’s true that real estate is a high-debt sector and rising rates will typically increase costs of borrowing money. However, many REITs have locked in cheaper debt costs and have the fundamental soundness to perform well even as rates are rising.

There are other important factors to consider when assessing the historical performance of these types of investments. REITs have been both positively and negatively correlated with the S&P since 2005, but these correlations vary considerably by sector and industry. For example, industrial REITs, buoyed by the boom in e-commerce and the corresponding need for warehouse space, have proven to be the least interest-rate sensitive over the past 10 years.

Typically REITs perform worse when rates rise quickly and sharply instead of at a more gradual pace. In 2017, the total returns of the FTSE Nareit All Equity REITs index rose 8.7 percent, while total returns for the S&P 500 increased 21.8 percent — but 2018 is already playing out more favorably for real estate investments. The FTSE Nareit All Equity Index outperformed the S&P 500 for the third straight month in May, rising 3.5 percent, compared with the S&P 500’s 2.4 percent increase.

Other Factors

Investors may ignore strong real estate fundamentals in a rising-rate environment and focus too closely on interest rates. Rising rates typically mean the economy is performing well, which typically leads to increased demand for real estate, rising real estate prices and increased rent revenues. Overall current consumption and confidence levels are strong, so real estate is expected to continue to do well fundamentally in this favorable macroeconomic environment.

Further, REIT’s tend to provide an inflation hedge due to their typically high long-term debt. In fact, REIT dividend growth has outpaced inflation in 18 of the past 20 years.

Rising rates warrant close monitoring for REIT investors, but barring significant economic deterioration or a bear market, investors may not see further negative impact on REITs from higher rates.