Real estate: Rising interest rates wreak havoc on REITs

We prefer REITs with reasonable leverage, moaty assets, demonstrated historical success across economic cycles, identifiable growth drivers and reasonable margins of safety.

Todd Lukasik, CFA 9 July, 2015 | 5:00PM

We expect REIT prices to generally move inversely with changes in long-term government bond yields. Although higher interest rates would take some time to show up in REIT financial metrics, eventually higher rates could cause higher debt financing costs, put pressure on traditional after-interest expense measures of REIT cash flow (such as funds from operations, adjusted funds from operations and funds available for distribution) and lead to higher cap rates, which could pressure investment spreads. Also, to the extent that low interest rates have diverted investor funds to REITs searching for higher yield, funds could flow out of REITs if interest rates rise, pressuring commercial real estate and REIT valuations.

Although rising interest rates might signal a strengthening economy, which could benefit real estate fundamentals, we do not expect the macro environment to improve enough to offset what could be another 200-basis-point rise in U.S. government bond yields to levels nearer historical norms.

While the potential negative impact of rising interest rates remains a key concern for REIT investors, U.S. REIT management teams seem less concerned. The majority of U.S. REITs have improved their balance sheets since the last downturn and appear as a group to remain more conservatively leveraged than the last boom in the mid-2000s. Moreover, upcoming maturities for many U.S. REITs over the next few years still carry interest rates that far exceed current borrowing costs, so even a 100-basis-point rise in rates from here would have a negligible impact on cash flow, at least over the medium term.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
HCP Inc31.14 USD-4.97

About Author

Todd Lukasik, CFA

Todd Lukasik, CFA  Todd Lukasik, CFA, is a senior equity analyst for Morningstar.