When interest rates spiked in early 2018, income related investments such as Real Estate Investment Trusts (REITs) experienced a sell off. The FTSE NAREIT Equity REIT Index returned a negative 8.2% in the first quarter of 2018.¹ Income producing investments will frequently experience a sell-off in the face of a sudden spike in interest rates. Does this mean that you should not own REITS when interest rates increase?
Intuitively, it makes some sense that income producing investments such as REITs would become less attractive when interest rates increase.
Owning REITs in a Rising Interest Rate Environment
As interest rates rise, the income produced at the current price is worth less, so prices will need to fall in order for the yield of the investment to reach the new equilibrium interest rates. For a bond investment with a fixed coupon this makes sense. In the case of income producing equities such as REITs, the income produced by the investment is not a fixed amount. In fact, the income stream from an equity may actually increase over time; even during periods of rising interest rates.
The Fed will typically increase interest rates in the context of a strong economy where they will raise rates to keep the economy from growing too rapidly and to keep inflation from increasing too quickly.
In a strong economy, vacancy rates, rents collected, and the overall real estate market tend to improve. These improvements are an overall positive for real estate investors.
So, in the long run, an increase in interest rates may not necessarily be bad for REIT investors. It seems that traders will sometimes reflexively sell all income producing “bond proxy” equities when interest rates spike. This becomes a self-fulfilling prophecy where traders will dump investments like REITs worrying about an impending price decline in REITs. This selling pressure can cause the price decline that traders had feared in the first place.
What’s Best About REITs in a Rising Interest Rate Environment
Taking a longer-term view, REITs have not necessarily performed poorly over a full interest rate tightening cycle. For example, the Fed increased the Fed Funds target rate from 1.25% to 5.25% from 2004 through 2006.
Here’s how the FTSE NAREIT Equity REIT Index (a major index covering publicly traded US equity REITs) performed during the last interest rate tightening cycle from 2004 through 2006:²
While there may be a short-term pull back in pricing, REITs are not necessarily poor performers over a full interest rate tightening cycle. Other more fundamental factors such as the general health of the economy and the health of the real estate market can have a greater impact on the performance of REITs than changes in interest rates.
Concern over REIT exposure to brick and mortar retail in the current environment where online shopping is becoming more popular is a legitimate concern. However, this concern has nothing to do with interest rates. As with all investments, diversification is critically important. Rather than purchasing individual REIT holdings, an investor can access a basket of REIT holdings through an exchange traded fund (ETF) and typically gain exposure to over a hundred REITs in a single ETF.
While it’s impossible to predict returns on REITs going forward, recent history has shown that long term performance of REITs is driven by fundamentals and not by the direction of interest rates.
The NARIET Equity REIT Index is a market capitalization weighted index of publicly listed U.S. equity Real Estate Investment Trusts (REITs).