Are REITs Beneficial During a High-Interest Era?

When interest rates rise, investors run for cover towards any good asset that they can find. Alternative investments, like real estate investment trusts (REITs), can be a good option, depending on the market cycle. Let’s see how REITs performed during periods with high and low-interest rates.

REIT Recap

A REIT is a publicly traded security that invests in real estate through properties or mortgages, and are available on major exchanges like stocks. As a result, REITs offer high levels of liquidity (a rare quality when dealing with real estate). The trusts often specialize in specific property types, such as residential apartments, commercial buildings, warehouses, or hotel facilities. REITs are also available in regional variants, concentrating on real estate in specific countries/regions like the U.S., Europe, China, or Japan.

REITs offer many benefits, including diversification, the aforementioned liquidity, a small amount of investment, income distribution, and tax benefits (depending upon local laws).

REIT Returns vs. Interest Rates

During periods of economic growth, REIT prices tend to rise along with interest rates. The reason is that a growing economy increases the value of REITs because the value of their underlying real estate assets increases. In a growing economy, the demand for financing also increases, resulting in increased interest rates. Conversely, in a slowing economy, when the Fed is tightening money, the relationship turns negative. This relationship can be seen in the following chart, which details the correlation between REIT total returns and the yields on 10-year Treasuries from 2000-2019.

For the most part, REIT returns and interest rates had a positive correlation, moving in the same direction. This is evidenced primarily between 2001-2004 and 2008-2013. The periods of inverse correlation, right after 2004, 2013, and 2016, all relate to Fed monetary tightening policies, reversing the actions of monetary stimulus actions that were put into place mainly after recessions. Here interest rates rose but REIT values decreased.

Further bolstering this argument is a study done by the S&P, which analyzed six periods beginning in the 1970s where the yield of the 10-year Treasury grew significantly. The study compared the increased interest rates to REIT and stock performance during those periods. The information is presented in the following table.

Of these six periods of interest rate increases, REIT returns increased during four of them and outpaced the stock market during three of them.

However, there are other factors and other detailed observations to consider, which may indicate positive or negative returns for REIT investments depending on the interest rate environment.

The biggest factor is that not all REITs are created equal. First and foremost, REITs operate in many types of industries. These include healthcare, hotel, residential, industrial, and many more. Each of these industries has different variables in play that react differently to the economic environment. Another important factor is the debt profile of a REIT; how much financing they take on to grow their business. The debt profile determines a REITs ability and timeframe to pay down debt, which will be impacted by different interest rate environments.

The observations discussed indicate that REITs may not really have any dependency on interest rates scenarios and that there are many other factors at play in determining how a REIT will perform during times of different interest rates. The returns from REIT investments may actually remain free from interest rate variations. As with any investment, it is crucial to look at the specific REIT in question, its performance, dividend payout history, and debt levels.

REIT Benefits to Investors

There are other benefits of REITs, which make them a good investment choice during varying interest periods:

Income Opportunity

REITs are considered yield-based securities. While they can appreciate in price, a considerable portion of REIT returns is from dividends. REITs avoid having to pay corporate tax if they distribute at least 90% of their income to their unitholders. This tax break results in a regular distribution of dividend income to REIT shareholders, and the effective net yields are often higher than the ones from bonds (or stocks), even in cases of high-interest rates.

Global Diversification

REITs offer exposure to global markets. Since the 1990s, the U.K., Singapore, Japan, Australia, the Netherlands, South Africa, and many others countries have enabled REIT listings, allowing investors to take exposure in real estate markets of foreign nations. For example, if the local real estate market in the U.S. tanks due to the effects of higher interest rates, a U.S. investor with exposure to the Singapore real estate market can benefit if he holds REITs in Singapore in his portfolio.

Sector Specific Exposure

In the event of rising interest rates, not all the sub-sectors within real estate may get hit adversely. For example, residential rents may suffer, but shopping centers in prime locations may not. Careful study of the real estate market, the impacts of interest rates on a specific sub-sector, and on specific REITs based on its underlying property holdings, can make REIT investments profitable no matter the interest rate impact.

The Bottom Line

After looking at correlation patterns and historical data, it appears that returns from REITs vary during different interest rate periods, but for the most part have shown a positive correlation during increasing interest rates. After careful study and proper selection of real-estate sub-sectors and geographic regions, investors can consider REITs a good investment for diversification alongside traditional stocks and bonds.

Read the original article on Investopedia.