The Impact Of Interest Rates On Real Estate Investment Trusts

By David Harper AAA

A real estate investment trust (REIT) must pay out at least 90% of its taxable profit as a dividend to shareholders, which makes REITs relatively high-yield instruments. In fact, from the perspective of total return - dividends plus price appreciation - REITs behave like a typical small-cap stock. But unlike a small-cap stock, most of the expected return of an REIT comes not from price appreciation but from dividends. In fact, on average, about two-thirds of an REIT's return comes from dividends. One downside of this for investors is that as a high-yield investment, an REIT can be expected to exhibit sensitivity to interest rate changes. In this article, we explore this relationship. (For background reading, see What Are REITs?)

Relatively High Yields
In Figure 1, we show the median yield for each REIT sector as of September 2004 as an example of the risk an REIT can present. The top of each bar is in the 75% yield; the bottom is in the 25% yield; and the break from green to blue in the middle is the median yield.

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Figure 1: Yields in different REIT sectors

You can see that yields vary by sector. As of September 2004, the median yield among all REITs (the bar furthest on the right) was about 5.5%, but the yields were dispersed: the 25% yield (the bottom of the blue portion) was about 4% and the 75% yield was more than 6.5% (the top of the green portion). This means only half of the REIT yields were between 4% and 6.5% while the other half of REIT yields was outside this range. At the same time, the yield on long-term U.S. government treasuries was less than 5%. This suggests that if your goal is income, you might do better with an REIT, but you would assume additional risk. The

REIT Total Returns Compared to Interest Rates
Conventional wisdom says that higher rates are generally bad for REITs. The most popular REIT index is the NAREIT Equity REIT Index. Figure 2 compares the value of the NAREIT Index to the 10-year Treasury bond (T-bond) from the beginning of 1972 to almost the end of 2004:

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Figure 2
Copyright
NAREIT Index
Annualized Return for Period Ending September 2004
1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year
25.6% 26% 20.4% 18.6% 18.8% 13.7% 9.2%
Table 1

Unfortunately, we can probably assume that past returns such as these cannot be replicated into the future over the long run for the industry as a whole. There will be exceptions in the short-term.

REIT Price Returns Compared to Interest Rates
Let's focus on just the price component of REIT stocks. In Figure 3 below, we compare the same 10-year Treasury bond rates to a price-only index. In other words, we exclude dividends and isolate only on price changes to see what would happen to $100 if it were invested in 1972.

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Figure 3
Copyright funds from operations (FFO). While such gains could be replicated going forward, it is unlikely. Further, it is entirely possible that prices could revert to prior multiples (for example, price as a multiple of FFO).

Second, the medium-term interest rate is low by historical standards. It is entirely likely that this interest rate will edge upward. If the 15 years of inverse correlation between rates and REIT prices shown above continued, then REIT prices would suffer.

Summary
The 15-year period examined above shows there is a strong inverse relationship between REIT prices and interest rates. On average, it would be safe to assume that interest rate increases are likely to be met by REIT price declines. Of course, reaction by sectors will vary. For example, some argue that in the case of residential and office REITs rising interest rates would drive up REIT prices because increasing rates correspond to economic growth and more demand. But you will need to be selective in such an environment. The good news about REITs is that high yields are a sort of hedge against price declines: if you buy a high-yield REIT, any price decline will be mitigated by high income in the meantime.

To learn more about REITs, see Basic Valuation Of A Real Estate Investment Trust (REIT) and The REIT Way.


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