Are investor fears of REITs’ rising-rate vulnerability off-base?

As decades-high inflation forces policymakers to reverse sharply from the accommodative stance they’ve taken over the course of the pandemic, many investors are deeply concerned about the impact of the climate of rising rates on REITs. But according to one leader in the space, a lot of that concern is already priced into the share prices of listed REITs.

“When I look at REITs’ leverage today, the average leverage level of REITs for example is about 30% to 35% in the U.S., versus 60% to 65% at the time of the financial crisis in 2008-2009, and 80% in the late 70s and early 80s,” says Corrado Russo, managing partner and head of global securities at Hazelview. “So I think they’re financially much stronger than before.”

From a valuations standpoint, he explained that the value of a piece of commercial real estate essentially depends on the cap rate, which is an investor’s expected return from a property less the expected growth in operating income from the property. While interest rates might be pushing investors’ expected returns up, those are historically offset by anticipated growth in operating income given higher rates are being driven by record inflation.

The upshot, then is that values don’t necessarily have to go down given that higher return requirements have historically been offset by rising cashflows due to rising rents as a function of inflation.

“We find that during a rising rate environment, there’s always a balancing act between increasing rates to tame inflation and not disproportionately impeding economic growth. Because of that, there’s typically much less correlation between cap rates and interest rates than people think and it is not typically 1 for 1,” Russo says.

Despite the popular perception of REITs not performing very well in rising-rate environment, Russo says the data doesn’t actually bear that out. Analysing Bloomberg data over the last four interest rate-hiking cycles, Hazelview has found that REITs actually do poorly at the beginning of a rising-rate cycle as the market anticipates and immediately prices in the risks of higher policy rates.

“What you actually see is when rates start rising, REITs do very well both on an absolute and relative basis,” Russo says. “If you look at the last four rate-hiking cycles, REITs posted a 12% average return on an absolute basis, and outperformed the equity markets by almost 300 basis points.”

_{*Source: Hazelview analysis of Bloomberg data as of January 31, 2022. Equity performance based on SP 500; Global REIT performance based on FTSE EPRA/NAREIT United States Total Return Index}

If history’s any guide, REITs are actually a good place for investors to be when the pain of rate hikes is already priced in, which is consistent with the current behaviour in the markets. To help minimize the possibility of a policy misstep, the Bank of Canada is leaning on forward guidance; when announcing its last fifty-basis point hike, the central bank telegraphed the potential for more supersized moves in succeeding meetings, and Deputy Governor Paul Beaudry indicated that it may go at least to the top end of its neutral range of 3% by the end of the year.

“There’s a good chance markets are pricing in a rate hike to 3.5% already,” Russo says. “They’re also pricing in a lot of different variables like inflation, the outlook for rental growth, where rents will go, opportunities for development and acquisitions, and so on.”

He believes investors should be weighing one of two scenarios: either rates will rise to less than 3% in the next 12 months, in which case there should be a rebound in the market; or rates will rise beyond 3%, which means there’s more pain to come. And based on what he’s seeing and hearing in terms of consumer confidence, companies starting to reduce hiring, and the prospect of a growth slowdown, Russo believes inflation should ease more quickly as negative consumer sentiment starts to impact consumption. The fear of rising rates could help curb demand to the point where central banks don’t have to actually hike by as much as they’ve declared they would.

From where Russo sits, REITs are trading at a good entry price at the moment, with valuations trading at below Net asset values and replacement cost. And the impact of recent rate hikes on borrowing costs has been mitigated by many of the better-quality REITs.

“Most [who operate in the REIT space] have locked in their debt into long-term instruments … Unless you’ve been living under a rock for the last three years, everybody expected this to eventually happen, so they’ve been working to make sure the debt within their capital structure is long term.”