Many dividend investors wonder how higher interest rates will impact REITs, and for good reason.

REITsOver the past few years, interest rates have fallen to their lowest levels in recorded history.

This has created a challenging environment for income investors who previously enjoyed healthy, low-risk returns from money market funds, CDs, and Treasury bonds.

In fact, since the darkest days of the financial crisis, many yield-starved investors have been forced to search elsewhere for their income needs, including bond alternatives such as real estate investment trusts (REITs).

As a result, the entire real estate industry outperformed the market even during one of the longest and strongest bull markets in history.

Since March 2009, the Vanguard REIT Index (VNQ) returned roughly 400%, outpacing the S&P 500’s total return of about 300%.

However, now that interest rates are finally on the rise (the chart above shows the 10-year Treasury yield over the last year), many dividend investors are understandably concerned about whether or not REITs are still a good sector to own.

Let’s take a look at the long-term history of how REITs respond to varying interest rate environments to see which ones, if any, are most likely to continue doing well in the coming years.

More importantly, find out what REIT investors need to know to better manage the risk in their portfolios as interest rates potentially rise.

Are Higher Interest Rates Bad for REITs?

Interest rates have never been this low for this long in human history, making many of the academic studies about rising rates potentially less relevant.

The good news is that we have some real-time data to analyze on the impact of higher rates on REITs because yields are up sharply since last summer.

In fact, the 10-year Treasury yield has increased more than 120 basis points since the start of July 2016, nearly doubling to reach about 2.6% today.

While that might sound like a significantly higher yield, you can see that it actually remains very low compared to the 10-year Treasury yields recorded over the last 60 years:

REITs

Source: Federal Reserve Bank of St. Louis

The S&P 500 Index has returned over 14% since rates started rising last summer, but many high-yielding, low volatility dividend stocks have not been so fortunate.

The table below shows the total return from 6/30/16 through 3/15/17 for a number of popular high dividend ETFs and sectors.

You can see that each of these groups of dividend stocks trailed the market, and three actually lost money over this period, recording a negative total return.

REITs were the worst performing group, losing 6.5% to trail the S&P 500 by a whopping 20.9%!

REITs

Source: Simply Safe Dividends

There are two reasons why interest rates matter to REITs, and both have to do with the underlying business model of this high-yield industry.

REITs exist so that the companies that own the properties can avoid paying corporate taxes as long as they distribute 90% of taxable income as unqualified dividends.

This means that REITs aren’t able to retain their earnings or adjusted funds from operations (AFFO – the REIT equivalent of free cash flow).

Thus, in order to grow, REITs need to raise external debt and equity capital from investors. As a result, higher interest rates increase a REIT’s cost of debt and make it incrementally harder to achieve profitable growth.

That’s especially true because REITs frequently use secondary offerings (i.e. they sell new shares) to raise growth capital.

Realty Income (O) has more than tripled its share count since 2005, for example:

REITs

Source: Simply Safe Dividends

Management has to make sure that any new properties it buys are still accretive to investors, meaning that the additional AFFO growth is enough to offset the dilution it took by issuing new shares to fund the property acquisitions.

In other words, AFFO per share needs to continue growing in order for the dividends to grow in a sustainable and secure manner.

However, when interest rates rise, bonds, including risk-free Treasury bonds, decline in value, causing their yield to rise.

REITs compete for new capital with bonds, as well as savings accounts, money market funds, and CDs.

Some investors who own REITs today might be inclined to sell their shares if rates rise because they can now achieve similar but less risky yields elsewhere.

To put it another way, because REITs are often seen as bond alternatives, higher interest rates could mean decreased demand for REIT shares, causing a REIT’s yield to rise.

While that’s great for dividend investors looking for new places to put money to work, it can also be a problem for the REIT’s long-term growth prospects.

That’s because the higher a REIT’s valuation (i.e. share price), the less new shares it takes to raise growth capital.

In other words, the less dilution to existing investors is needed in order to continue growing a REIT’s AFFO, and thus its dividend.

Think of it this way. Suppose a REIT currently yields 5%, and management is able to buy new properties at a capitalization rate (annual net income / purchase price) of 7%.

Even if the REIT has to raise 100% of the capital to buy a property by selling new shares, then AFFO per share will still increase, and so will the dividend.

And if the REIT buys the property with a 50/50 mix of equity and debt (with an interest rate of 4%), then the amount that AFFO per share increases is even more due to less dilution and an even lower weighted average cost of capital, or WACC.

However, if interest rates increased to 6% and a REIT’s shares fell enough to raise the yield to 8%, then suddenly the ability to buy that property with 100% equity capital disappears.

The 8% yield a REIT would have to pay on its newly issued shares is more than the 7% capitalization rate it earns on its property, destroying shareholder value.

In other words, the REIT’s cost of capital has risen high enough to not make the deal accretive.

REITs essentially have an optimal growth sweet spot, in terms of their yield. If shares are too expensive, then the yield is too low for investors to earn the income they need.

But if shares are too cheap for too long (due to higher interest rates), then the REIT gets cut off from growth capital and can’t expand its property portfolio and dividend.

So with the Federal Reserve predicting that interest rates will rise by about 2.5% in the next few years, are REITs a bad investment idea?

Not necessarily. What it does mean, however, is that you need to stay diversified and be highly selective with which REITs you add to your portfolio.

The Best REITs Can Still Grow Despite Higher Interest Rates

It’s important to note that REIT share prices aren’t just affected by interest rates but can and do trade on other factors, including a REIT’s fundamentals, long-term growth prospects, and dividend growth history.

As you can see, REITs have been positively and negatively correlated with interest rates during different periods of time since 2005, indicating that there are other factors influencing their returns.

REITs

Source: Hoya

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