Download REITs and Rising Interest Rates

REITs and Rising Interest Rates: Not a Credit Worry
January 5, 2017
The raising of the Fed Funds rate target range at the Federal Reserve’s December 2016 Open Market Committee meeting, and
the expectation of fiscal stimulus following the election of Donald Trump, have raised market expectations for a sustained
period of higher interest rates. What does this mean for the creditworthiness of REITs?
REITs (formally, Real Estate Investment Trusts), created in the last days of the Eisenhower Administration, are companies that
finance or own income-producing property, and are similar to mutual funds. REITs typically pay out all of their taxable income
to shareholders as dividends, and do not pay income taxes themselves. REITs allow small investors to more easily invest in
professionally managed, large commercial properties. REITs are financed by common stock and preferred stock and/or debt,
and own a wide array of property types including shopping centers, hotels, nursing homes, apartments, warehouses, selfstorage centers, student housing, timberlands and office buildings.
A REIT can be thought of as a portfolio of bonds, with each property owned being a bond, and the rental payments to the REIT
being the bond’s coupons. With this in mind, one risk from an interest rate perspective is the maturity structure of the leases.
Retail net lease properties (where the tenant pays rent to use the property, as well as the property taxes, insurance and
maintenance) and health care properties (many of which are rented on a net lease basis) tend to have relatively long leases.
Rising rates serve to diminish the value of those rent cash flows. Self-storage properties, warehouses and apartments, in
contrast, have shorter-term leases which are generally less vulnerable to rate increases. That said, the REITs in which
Spectrum invests are investment-grade at the senior level, and typically fund themselves with moderate levels of debt with
laddered maturities, and preferred stock. This funding mix helps to hedge a REIT’s interest rate risk, strengthen its liquidity
and lower its cost of funds, thereby supporting creditworthiness.
In addition, even if interest rates rise, capitalization (cap) rates on properties may not necessarily rise in tandem. A cap rate is
the rate of return on a property based on its expected cash flows. For example, if a property generates $1 million/year in
revenue, and is bought for $20 million, its implied cap rate is 5% ($1mm÷$20mm = .05, or 5%). This is similar to valuing a
bond. Cap rates and property values are a complex function of the shape and position of the yield curve; the type, quality and
location of the property; market demand; and property supply, among other factors. Spectrum notes that the US economy is
relatively strong, with limited excess supply. Also, the REITs in which we invest focus on higher quality properties, which tend
to hold their value. Based on these characteristics, REIT cap rates could prove resilient, and not rise as much as overall interest
rates. Moreover, potential fiscal stimulus should support demand for properties, and thus property values.
REITs have proven to be sturdy performers during the recent financial crisis, underscored by solid property portfolios and
skilled management teams. Although rising interest rates could diminish the value of REIT industry cash flows, and hence
underlying property values, these should be more than offset by numerous strong REIT credit fundamentals.
John J. Kriz, Senior Vice President
Joe Urciuoli, Executive Director
Spectrum Asset Management, Inc. is a leading manager of institutional and retail preferred securities portfolios. A member of the Principal Financial Group® since 2001, Spectrum manages
portfolios for an international universe of corporate, insurance and endowment clients; mutual funds distributed by Principal Funds Distributor, Inc.; and preferred securities separately
managed account solutions distributed by Principal Global Investors, Inc.
A member of the Principal Financial Group®