The Impact Of Interest Rates On Real Estate Investment Trusts

by David Harper,CFA, FRM (Contact Author | Biography)

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

Relatively High Yields
In Figure 1, we show the median yield for each REIT sector as of September 2004. 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.

Figure 1

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%. Therefore, if your goal is income, you might do better with a REIT, but you would assume additional risk.

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:

Figure 2

Keep in mind that the chart of the NAREIT Index shown above includes both income and price gains. The blue line starts at an indexed value of 100 and is plotted against the vertical axis on the right. The green line is charted against the left vertical axis.

Although we have over 30 years of data, it is hard to draw conclusions because most of the period was dominated by a secular (i.e. long-term) decline in interest rates. The strong negative 66% correlation between the two instruments suggests an inverse relationship. However, such implications would be more compelling if the few periods of sustained rate increases were met with declines in the NAREIT Index. Instead, increases occurred simultaneously: during the five-year period from December 1976 to October 1981, 10-year Treasury rates leaped from 6.87% to 15.15% (the peak of the green line), and the value of the NAREIT Index gained an impressive 15.8% during the same period.

REITs did even better in later years as interest rates declined. Table 1 shows the annualized return for the NAREIT Index. REITs had a good run over the five years preceding 2004:

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.

Figure 3

Although the overall correlation is weaker, there is a strong inverse pattern over the last 15 years in the period shown above. In fact, from the 1989 point, Figure 3 shows a virtual mirror-image relationship between the price component of the REIT index and the medium-term interest rate. For those considering a REIT investment as of late 2004, this would be a "red flag" for two reasons. First, in the five years preceding 2004, the index produced an annualized gain of 18.8%, including a steep annualized gain of 26% over the two preceding years. During that period, therefore, price gains (as a percentage) exceeded fundamental gains, as measured by earnings, cash flow, or 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.

by David Harper (Contact Author | Biography)

In addition to writing for Investopedia, David Harper, CFA, FRM, is the founder of The Bionic Turtle, a site that trains professionals in advanced and career-related finance, including financial certification. David was a founding co-editor of the Investopedia Advisor, where his original portfolios (core, growth and technology value) led to superior outperformance (+35% in the first year) with minimal risk and helped to successfully launch Advisor.

He is the principal of Investor Alternatives, a firm that conducts quantitative research, consulting (derivatives valuation), litigation support and financial education.