ast week, one of our readers sent me a well-timed message asking about the effects of interest rates on REITs and other real estate investments. He asked if interest rates really matter when making real estate investments, and if the premium that’s baked into asset inflation offsets the premium of higher interest rates in valuing the assets of a REIT.
REITs are complicated instruments as I addressed in the first part of this series. Not only do they share similarities and correlations to small and mid-cap stocks, but they are valued on net assets and a set of relatively fixed cashflows, which are derivatives of property values and local market conditions. These properties are valued based on appraisals and complex financial models which aim to calculate acquisition and reversion yields (cap rates), representing a proportion of Net Operating Income (NOI) to property value.
Briefly, cap rates rise as interest rates rise and property values remain the same. This means NOI increases as a proportion of property value but are devalued compared to inflation (which interest rates predict). Cap rates contract as property values stay the same and rents become lower, and cap rates remain the same as property values grow proportionately to rents and operating incomes.
REIT returns aren't difficult to track. Because of their size they are exposed to higher betas with small and medium cap stocks and real estate sector risk, but they can also be a suitable hedge against inflation. Real estate returns have generally been positively correlated with interest rates due to the tight supply of space that allows rents to rise, offsetting a drop in value caused by rising interest rates.
Studies also found that the dividend yield on REITs is positively related to both expected and unexpected inflation, so the dividend yield ‘‘improves’’ the hedging capabilities of REIT investments.
Valuing REITs can be tricky though. sector exposure is a critical factor in REIT performance. Macroeconomic conditions are a large contributor to this volatility: rent collections can forecast month-to-month performance and investor sentiment. For example, in 2020, Office and Residential REITs had rent collections below 85% for a portion of the year, which plunged returns in both sectors and slowed their recovery. Data Centers, which have seen skyrocketing demand, sustained rent collections above 97% and demonstrated growth, pushing performance above other sectors.
The quality of those tenants trickles up to the balance sheet for any REIT, whose dividend and valuation growth depends on steady cash flows, rent escalations, and long-term leases.
But dividends are only half of the consideration when making an allocation to REITs. REITs can function both as investments into an established portfolio with strong consistent cash flows, or a new business with strong growth perspectives. New REITs will consistently leverage new and existing assets to make investments into a portfolio, growing the NAV and the share price as cash flows establish. Existing REITs will issue new shares of stock to make investments into the portfolio and redistribute those cash flows as dividends later. Generally, established REITs with consistent share prices will have a higher dividend than growing REITs.
Intangibles are also worth considering when valuing the quality of underlying properties and business models. For example, student housing may not seem like a resilient asset class, however rent collections remain astronomically higher than residential (c.98% vs c.89% respectively) despite sharing similarities between assets.
Investors with allocations to U.S. equity investments, particularly U.S. small and mid-cap equities may already have exposure to REITs within their portfolios. Before receiving their own individual sector, REITs fell under the financial sector and remain in financial ETFs to this day. Many investment managers, both active and passive, maintain exposures to REITs within their portfolios.