How Will a December Rate Hike Affect REITs?

Posted on December 6, 2016

It has been a rewarding year for real estate investment trusts (REITs) as their performance has continued to outpace the Standard & Poor’s 500 by a substantial margin. The National Association of Real Estate Investment Trusts (NAREIT) reports that the total return of the FTSE/NAREIT All REIT index was 12.6 percent through September 30, compared with 7.8 percent for the S&P 500. However, amid these high returns, investors are reeling back expectations in response to reports that Federal Reserve officials believe the economy’s steady growth and low unemployment rate have strengthened the case for raising interest rates.

The instinctual reaction to an anticipated hike might be apprehension because rising rates commonly hurt investments dependent on debt financing. However, the long-term performance of REITs correlates more with the economic well-being of the country than with rate increases, as shown by previous rate hike cycles. According to Investment News, REITs averaged a 1.93 percent decline 12 months before an interest rate hike, and a 0.45 percent gain three months before that. Three months after a hike, REITs gained 1.44 percent, followed by a 3.4 percent gain six months afterward. By the time a year had elapsed following a rate increase, REITs had climbed 7.71 percent.

Furthermore, savvy investors take advantage of rate hikes and find yield in specific sectors. “If interest rates are rising for the right reason, there’s growth in the underlying economy [and] you want to be in the sectors that have shorter lease terms,” Drew Babin, senior research analyst at Robert W. Baird, told “You want hotels, self-storage, apartment sectors—[places] where landlords can take advantage of the rate hike. But if we have a rate hike and [the ten-year Treasury] goes back down to 1.5 percent, you’ll want to own REITs with longer leases like health care sectors, where they have that stability.”

Investors should be sure to take a step back and look at the bigger picture in the midst of a rate hike. REITs continue to be a source of high yield and are currently trading at historically high valuations.

While a Fed rate hike will make it more expensive to take out loans, the most immediate focus should be on Treasury bond yields, which are a more crucial market factor for the success of REITs. The current ten-year Treasury yield is 2.4 percent. According to NAREIT’s Industry Financial Snapshot for October, the FTSE NAREIT yield for all REITs is 4.25 percent (and 3.91 percent for all equity REITs). Therefore, REITs are still attractive with higher yields, and are also required by the Internal Revenue Service to pay out at least 90 percent of their taxable income to unitholders.

As long as REITs continue to provide a solid source of income, investors likely will remain in the sector.

Andrew Howard-Johnson, The Magazine of The Urban Land Institute .