Rising Rates and REITs Return by Arthur Hurley, CFA, ColumbiaManagement
- While REITs typically demonstrate some interest rate sensitivity and sometimes have a “knee-jerk” reaction down when rates first move up, performance has often rebounded.
- An improving economy has the potential to dampen the effects of duration risk and interest rate sensitivity, given the increased earnings and dividend growth REITs can produce.
- The balance of income and organic growth attributable to REITs can offer an attractive investment opportunity, regardless of the interest rate environment.
Do Real Estate Investment Trusts (REITs) always underperform when interest rates rise? Many investors believe they do. However, analysis of historical REIT performance provides strong evidence to the contrary. Like many other income-oriented investments, the income characteristics of REITs may influence returns. However, we believe interest rates are not the only determining factor to REIT performance. There is more to the story.
Going back to 1980, there have been 21 periods when the 10-Year Treasury yield increased 50 basis points or more. During these periods the FTSE NAREIT All Equity REIT Index provided an average total return of over 5%, which notably outperformed the Barclays U.S. Aggregate Bond and Barclays Treasury Indices, and slightly lagged the S&P 500 Index (Exhibit 1). The REIT index outperformed equities 57% of the time, bonds 62% of the time and Treasuries 67% of the time. Additionally, when considering performance one year after rates increased, the REIT index provided average positive total returns greater than 16%, outperforming the three other indices. Essentially, the analysis gives evidence that REITs typically demonstrate some interest rate sensitivity and sometimes have a “knee-jerk” reaction down when rates first move up, but performance has often rebounded after the initial leg down.
Exhibit 1: Historical performance during periods of rising interest rates
Source: Morningstar, August 2014.
While a significant jump in interest rates would likely have a negative effect on investor demand for REITs and ultimately a negative effect on relative performance, we believe history has shown that the group’s performance has not been significantly impacted as a result of measured increases in rates. The balance of income and organic growth attributable to REITs is hard to match with other income-oriented investment options, ultimately creating the potential for an attractive investment opportunity, regardless of the interest rate environment.
We believe the U.S. real estate market overall remains attractive should the economy continue to grow, and fundamentals for the group remain strong. Interest rates are likely to rise in the not-too-distant future, but our expectations aren’t for a rapid increase or significant jump higher. We also believe ongoing economic growth may well drive increased demand for real estate, and the higher quality REIT portfolios. We expect net operating income growth to remain positive and dividend increases to be notable. We also expect occupancy rates to remain strong, currently at new peak levels and comfortably above historic averages.
Perhaps most importantly, it should not be lost on investors that REITs have not only interest rate sensitivity, but also economic sensitivity. This exposure to economic growth often allows REITs to hold up better than other income-oriented investments during periods when rates rise for good reason, such as improving economic conditions. For example, when the economy is improving, the underlying assets and fundamentals of REITs also benefit. The stronger labor markets ultimately result in higher occupancy levels and the ability to increase rents. As these factors demonstrate strength, they have the potential to at least dampen the effects of duration risk and interest rate sensitivity, given the increased earnings and dividend growth REITs can produce.
The Barclays Aggregate Bond Index is a market value-weighted index that tracks the daily price, coupon, pay-downs, and total return performance of fixed-rate, publicly placed, dollar-denominated, and non-convertible investment grade debt issues with at least $250 million par amount outstanding and with at least one year to final maturity.
The National Association of Real Estate Investment Trusts (NAREIT) Index is an index that reflects performance of all publicly-traded equity REITs.