Introduction
In recent years, the question we hear most frequently from prospective REIT investors is how REITs will perform in a rising rate environment. Setting aside the suddenly pertinent question of whether we are still in such an environment, our typical response has been that REITs have often been solid performers when interest rates are moving up. This is especially true if those rate increases are being driven by an economy that is strong enough to keep rents and net operating incomes growing quickly. This can offset the impact of both more expensive financing and the upward pressure on cap rates we might see when other income vehicles begin offering more competitive yields.
However, not all “interest rate increases” are the same, and this paper explores how REITs perform under different kinds of interest rate upcycles.
What Kind of Interest Rate Increases Do You Mean?
To many people, “interest rate increases” merely mean the Federal Reserve is increasing the Federal Funds target rate. Increases in the Federal Funds target rate tend to be long and steady and telegraphed well in advance, while both Treasury and corporate bond yields are much more volatile and sensitive to the day-to-day vagaries of financial markets. If the Fed is credibly reigning in inflation by hiking short rates, long Treasury rates may well move lower as the spread investors demand for longer-term lending narrows. On the other hand, if the market is worried that the Fed is being overly aggressive, corporate bond spreads may widen and yields may move up at the same time as Treasury yields of similar duration fall. As investors become concerned that the economy will weaken and corporate defaults will rise, they allocate to Treasury bonds in search of safety. In short, the term “rising interest rate environment” is often too muddled to be useful. Different types of interest rates have very different cycles.
The information and opinions presented in this research piece have been prepared internally and/or obtained from sources which AEW believes to be reliable; however, AEW does not guarantee the accuracy, adequacy, or completeness of such information.
1 REIT performance is measured by the MSCI US REIT index. Bond performance is measured using the Bloomberg Barclays US Bond aggregate that includes a value weighted mix of both sovereign and corporate bonds as well as various mortgage backed securities. Returns during rate cycles are not annualized and are based on daily data beginning at the bottom of the interest rate cycle. All returns are calculated using daily data and standardized trading years of 262 days. Nine month periods use 197 trading days and half years use 131 trading days. Due to weekends and other trading holidays, these periods may be slightly different than simply moving six, nine or twelve months forward or back from a given date, but they are a close approximation.
2 Long Term Capital Management was a large, highly levered hedge fund that nearly defaulted in 1998 before a Fed-led bailout stabilized the situation. A default would have triggered a global financial crisis due to the write-offs its creditors would have had to make, and credit spreads widened markedly before the bailout.
The information and opinions presented in this research piece have been prepared internally and/or obtained from sources which AEW believes to be reliable; however, AEW does not guarantee the accuracy, adequacy, or completeness of such information.
