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How Do Interest Rates Affect REITs?

How Do Interest Rates Affect REITs

Sometimes, you might hear that REITs are growing along with rising interest rates, whereas at other times, you might hear just the opposite.

So what exactly is the relation between REITs and interest rates? How do interest rates affect REITs in a real world scenario? We answer this perplexing question in an easy-to-understand way below.

About REITs

Real estate investment trusts (REITs) are firms that own, manage, or finance real estate assets that generate income.

They follow the mutual fund model of pooling investor money.

Both types of financial instruments deploy these funds in something difficult for individuals to do themselves.

In the case of mutual funds, this is a continuously managed basket of stocks.

For REITs, the asset invested is property.

After all, it is nearly impossible for one person to own, manage or fund several houses or corporate offices.

How Do Interest Rates Affect REITs

This is where these securities come in.

They let folks get a piece of the action from rental income and growth in property values without asking for too much time or money from them.

There are some aspects of REITs that investors should know:

  1. Real estate securities are traded just like stocks.
  2. About 90% or more of their net operating income comes back to shareholders as dividends.

These trusts work in many different kinds of real estate.

This could include apartment buildings, offices, malls, warehouses, cellphone towers, hotels, hospitals, etc.

Investors can choose the sector where they see maximum opportunity.

Types of REITs

There are broadly three categories of these financial instruments:

  1. Equity REITs
  2. Mortgage REITs
  3. Hybrids

The first type works directly in owning and managing properties.

Mortgage REITs (mREITs) create and manage mortgages that help fund real estate investors.

The last ones do a bit of both, as their name suggests.

Advantages

REITs have become a powerful tool for diversification, earning a steady dividend income and beating the impact of inflation.

Here are some key benefits of real estate securities.

REITs advantages

Easy access to real estate

Real estate investing was only accessible to large corporate firms before REITs came along in the ’60s.

They made it possible for common folks to get exposure to the property market.

For the first time, small traders could earn capital appreciation and dividends by investing in the property sector.

Diversification of Portfolio

As we explain later in the article, REITs are an excellent hedge against inflation.

The real estate market does not move in tandem with equities and other financial instruments.

Many investment management services suggest risk diversification by investing money in this asset class.

Passive Income

When Congress first approved the concept of REITs, they stipulated that shareholders would get back 90% of the net cash flow arising from the operations of these firms.

The idea was to ensure that these companies did not indulge in speculation with funds pooled from small investors.

Over time, this rule has made REITs popular as a source of passive dividend income.

Traders whose investment strategies revolve around getting a steady cash stream find them an excellent tool for this purpose.

Capital Appreciation

While they are popular for dividends, real estate securities offer some value growth over time, just like stocks.

An increase in the property values of the underlying assets drives their capital appreciation.

For example, commercial real estate and housing properties in small but growing cities often gain value as the town expands.

No Double Taxation

Corporate earnings are first taxed directly from them and then again when received as dividends by shareholders.

REITs are exempt from this double taxation process.

This frees up additional cash flow from their net operating income to distribute as dividends.

Moreover, the Tax Cut and Jobs Act of 2017 allowed a deduction on pass-through dividends up to 20% of total dividend income.

Most REIT income falls under this category, giving a dual benefit to investors.

Real Assets

Some folks prefer to be able to touch and feel the assets they put their money in.

Real estate investment falls squarely under this category.

Other examples include commodities like gold and silver.

Liquidity

Like stocks, REITs can be bought or sold on the share market. They are highly liquid.

Compare this to owning a physical house or a shop.

Finding a buyer at the right time and price is difficult if you choose to sell these assets.

This makes them highly illiquid and not a good investment when one is in a fix.

Access to Commercial Real Estate

Without REITs, there is no way for retail investors to get their money into hospitals, malls, cellphone towers, and so on.

Some of these sectors are burgeoning, and it helps to have a way to profit from their growth.

Disadvantages

Not all is good about REITs, though. Below are a few things folks should remember before putting their money into them.

 

REITs disadvantages

 

High Tax on Dividends

We mentioned earlier that REIT dividends are not taxed twice, which increases the pie to be distributed.

However, once it reaches the shareholder, the taxation is per ordinary income.

This is unlike returns from share trading, which incur favorable capital gains tax rates.

For those in the higher income tax slabs, this could mean a significant outgo if a lot of their money is invested in REITs.

Sensitive to Interest Rates

REITs can be sensitive to interest rate movements (we will explain why later).

When Fed action leads to rising rates, the net asset value of most of these securities starts to fall.

Hence, investors might see a significant dip in incomes during such situations.

High Fees

REITs have fairly high sales commissions and annual management fees, which can cost a pretty penny to the trader.

This is unlike stocks or ETFs, where there usually are no sales commissions, and expense ratios are nominal.

Susceptible to Market Trends

Just like shares, REIT performance can also depend on the prevailing environment.

For example, most of these securities are sector-focused, like hospitality, healthcare, or corporate.

If the underlying industry is doing badly, so will the associated REIT.

Take a recent case, shopping malls and commercial office spaces closed during Covid-19.

This precipitated a fall in the net asset value of many real estate investment trusts heavily invested in these avenues.

How Do Interest Rates Affect REITs?

Normally, REIT performance is positively correlated with interest rates.

But during a downturn, rate increases cause drops in their returns.

Confused? Let us explain this in more detail.

What Happens During Periods of Economic Growth

When the economy is doing well, consumer demand for financing purchases does too.

This implies everything – from housing mortgages to auto loans and credit card interest rates starts to increase.

After all, it is an opportune time for lending institutions and banks to raise their profits!

All this translates into higher interest rates.

Interest Rates

 

At the same time, more people open offices, buy houses, and take up rentals when they are positive about the economy.

This increases the net asset values of property-related investments because the underlying asset is in high demand.

To sum up, REIT incomes and interest rates rise in tandem when the economy does well.

Why Does This Change During A Downturn?

Now, consider what happens when the economy slows down.

Supply of goods shrinks as manufacturing activity falls, service sectors downsize and shut down offices, and so on.

This causes inflation to rise (because the supply of everything becomes restricted).

When it reaches a certain level, the Federal Reserve (or any central bank in any country, for that matter) steps in to cool it down.

The tool they use to do this is to raise the federal funds rate (the rate at which banks loan out money to each other).

When this happens, financial institutions pass on the increased rates to borrowers and those looking to save money.

This way, the monetary system mops up excess liquidity by getting people to put their assets in bank deposits and savings accounts, helping bring down prices.

But this time, the property market does not do well in sync.

In a slow economy, there is little demand for buying houses or opening new offices.

Hence real estate investments won’t perform, despite a rising interest rate environment.

In particular, mortgage REITs are more closely and directly impacted (in both scenarios, good or bad).

Are They Good Hedges Against inflation?

In a growing economy, REITs are an excellent hedge against inflation.

They do well when prices rise because the value of housing spaces and offices also go up.

As mentioned earlier, the only case when these securities don’t do this is when an economic slowdown causes runaway inflation.

To give some statistics, REIT returns have outpaced CPI inflation in all but two out of the last 20 years.

Those two exceptions were in years when the Fed tightened monetary policy.

Should You Buy REITs in a Recession?

There are two benefits of REITs during a recession: they pay out regular dividends and offer diversification at a time stocks are tumbling.

Dividend income is very important during a downturn because it is cash in hand when it is most needed.

Unlike the notional capital appreciation in stocks which can vanish during market crashes, REIT dividends are steady.

Moreover, they cannot decline to give them out – they are legally mandated to pay out 90% of earnings in this form to shareholders.

The second point is a bit more nuanced.

You don’t want to put all your eggs in one basket, especially when things are not good.

By investing some money in the real estate pie, you can hope that at least this part of your investment will be saved during a market crash.

But investors should remember that despite these benefits, REITs are not immune to a recession.

If economic growth is falling, so will real estate performance.

Do They Go Down When Market Crashes?

If the market crash is driven by broad-based economic distress, then REITs will not remain untouched.

However, they are likely unaffected if the fall is limited to certain sectors or a few large stocks.

REITs represent an entirely different asset class from equities.

Demand for houses, offices, and other real estate is typically unrelated to stock prices.

This makes them an excellent form of diversification.

When stocks crash due to temporary reasons, REITs will not follow suit.

However, when the whole economy tanks, it will also affect the real estate sector.

What Is the Average ROI on REITs?

Over the past 25 years, equity REITs have given an average return of 11.5%.

This is slightly above those from the S&P 500 (10.2%).

However, the stock markets have offered better RoI in recent years.

Much of the return from REITs is driven by dividend yield, which has remained consistently high over the years.

Moreover, real estate securities have shown lower volatility than equities, sometimes as much as half of the S&P 500.

Among the various subsectors in real estate investing, self-storage (18.8%) offers the best ROI, followed by industrial and residential.

Lastly, past performance is not an indicator of future results; hence these numbers are only meant for analysis.

We wish to clarify here that we do not offer any type of investment advisory services.

Final Thoughts

In short – if the market is up, a rising rate environment is good news for REIT investors.

If rates rise during an economic slowdown, it would just mean the reverse.

In most scenarios, REITs make for an excellent inflation hedge and a good way to diversify an equity-based portfolio.

They are also an excellent source of steady, passive income when the chips are down, and markets are in a tumble.

However, this is not to say that they are not susceptible to a worsening economy.

They are just as affected, and their performance will go down when this happens.

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Ritesh is an experienced copywriter who brings his decade-long work in corporate strategy and finance to bring analysis and insight into his writing.