Starlight Capital - Impact of Rising Interest Rates on REITs (2024)

Over the last 30 years, REITs have become the global standard for owning publicly-traded, investment grade real estate. Over 35 countries, including every G7 nation, have introduced REIT-like legislation to encourage investment in real estate. Investors in REITs have been rewarded with strong risk-adjusted returns on both an absolute and relative basis.

REITs Outperform Other Major Asset Classes

Source: Bloomberg Financial L.P. and Starlight Capital. Data from May 29, 1992 to May 31, 2018. REITs, Stocks, Bonds, and Commodities are represented by the Dow Jones U.S. Select REIT Index, the S&P 500®, Bloomberg Barclays US Corporate Total Return Value Unhedged USD Index, and the S&P GSCI, respectively. Past performance is no guarantee of future results. Chart is provided for illustrative purposes and reflects hypothetical historical performance.

However, recently investors have expressed concerns that REITs may underperform significantly as the Federal Reserve Bank continues to raise the Federal Funds Rate. The thinking is that REITs are highly-levered, bond proxies with very little growth. Therefore, if rates begin to rise then REIT cash flows will decline at a time when discount rates are rising. They fear the end result will be capital losses that offset the higher distribution yield and result in negative total returns.

REIT Performance During Sustained Periods of Rising Interest Rates

Source: S&P Dow Jones Indices LLC, Bloomberg, The Federal Reserve. REIT total returns are based on the FTSE/NAREIT Equity Index from Dec. 31, 1971, to Dec. 31, 1986, and they are based on the Dow Jones U.S. Select REIT Index after Dec. 31, 1986. Stock total returns are based on the S&P 500. Past performance is no guarantee of future results. Table is provided for illustrative purposes and reflects hypothetical historical performance.

During periods where the 10-year bond yield is rising, many other factors are present that are positive for REIT fundamentals. Rising long bond yields are usually associated with increased economic output and inflation, both of which are likely to be positive for REITs. Increased economic growth should result in the demand for more real estate as employment rises. As occupancies rise, rents should follow as growing firms are able to absorb higher rents. All of this should increase REIT cash flows, distributions and valuations.

REIT Income has Outpaced Inflation

Source: S&P Dow Jones Indices LLC; The Bureau of Labor Statistics. Data as of Dec. 30, 2016. REIT Income Return is calculated as the annual difference in return between the Dow Jones U.S. Select REIT Index (PR) and Dow Jones U.S. Select REIT Index (TR). Past performance is no guarantee of future results. Chart is provided for illustrative purposes.

Asset & Property Management

Collectively, these are the scale and scope advantages that accrue to a skilled operator with a large and clustered portfolio of assets. Skilled property management (operating individual properties) and asset management (optimizing the value of the portfolio of properties) should yield revenue gains and expense savings that allow for cash flow per unit growth, independent of market factors. These benefits tend to accrue to most of the portfolio and perpetuate into the future. For instance, newer, more efficient appliances purchased at a larger discount, unsecured debt issuances in the capital markets and lower property taxes from assessment appeals should all result in higher rents and/or lower expenses. Rolled out across an entire portfolio this should result in meaningful value creation through the business cycle.

Contractual Rent Increases

These represent return on past negotiations and result in current period revenue gains based on past period expenditures (leasing costs and tenant inducements). A quality real estate portfolio should see annual contractual rent increases across most (if not all) of the portfolio leases that don’t expire that year. Indexing these rent increases to inflation creates a natural inflation hedge to offset some of the impact of rising rates and capture some growth.

Positive Lease Renewals & Occupancy Gains

These levers are similar in that capital is required to retain an existing tenant or acquire a new tenant. Positive lease renewals result in increased revenue from the existing asset. Depending on the capital outlay required, this is generally cheaper and preferable to finding a new tenant. Occupancy gains involve securing a new tenant for an existing and unoccupied space. The capital required is generally higher but partially offset by the impact of taking vacant space off the market and tightening up current supply and demand fundamentals.

Accretive Acquisitions & Developments

The Real Estate Market is Affected by Changes in Physical and Financial Cycles

Source: AMP Capital, adapted from Barras, R. (1994) Property and the economic cycle: Building cycles revisited. Journal of Property Research, 11(3), 183-197. Past performance is not a reliable indicator of future performance. For illustrative purposes only.

Starlight Capital approach

At Starlight Capital, our goal is to add value by concentrating our investments into high quality REITs with several of these value creation levers at their disposal. REITs with more growth potential should outperform through the cycle but their value is especially important when economic activity accelerates, and inflation expectations and spot rates rise. Purchased when they offer us sufficient return for the risk incurred these investments should yield us strong risk-adjusted returns over the long term.

Additional Information

• Starlight Global Real Estate Fund
• The Case for Global Real Estate
• How REITs Generate Growth
• Download PDF