The Impact of Interest Rates on Real Estate Securities
April 25, 2011
How interest rate movements impact real estate securities is a complex but topical matter. After studying the historical performance of these securities, our findings indicate that, despite public opinion to the contrary:
• Not all interest rates move together
• Real estate securities have had surprisingly low correlations to interest rates
• More often than not, real estate securities have generated positive performance during periods of rising interest rates
In our opinion, these observations indicate that credit quality, yield spreads and underlying fundamentals play an equal or more important role in driving investment returns than interest rates alone.
Which Interest Rates are Changing and Why?
When discussing the impact of interest rates on real estate securities, one must consider which interest rates are moving and why.
When one speaks of “interest rates,” are they describing:
• Corporate bond yields moving in response to investor concerns about business credit?
• A spike in long-term bond rates due to inflationary pressures?
• A rise in short-term rates causing an inverted yield curve?
As the table below exemplifies, not all interest rates move together. In September of 2007, as the Federal Reserve began cutting the overnight Federal Funds target, the 10-year Treasury bond yield continued to oscillate considerably. In recent years, any causal relationship between the two rates appears tenuous at best.
How Have Real Estate Securities Historically Been Impacted By Increasing Rates?
Real estate companies, such as REITs, issue common shares, preferred shares, corporate bonds and secured mortgages. Each has a different claim on the company’s cash flow and assets. Some have fixed payment streams while others participate in the earnings growth of the company. Each security type will react differently to changing economic conditions.
In general, declining rates are viewed as advantageous for stock prices while increasing rates are unfavorable; however, studies show that equity REIT performance does not necessarily follow this pattern.
Since 1972, there have been nine periods of rising long-term interest rates—six were marked by positive REIT performance.
Why Have Real Estate Securities Shown Low Correlation to Interest Rates and Positive Performance During Periods of Rising Rates?
A linkage exists between interest rates and real estate fundamentals that mitigates the influence of interest rates on these securities. The dynamics that drive interest rates up—inflationary pressures from economic growth—tend to cause real estate fundamentals to improve, potentially offsetting some of the impact of rising rates through accelerated earnings, dividend growth and improved credit quality.
The near-term outlook for rates across the curve seems stable. Strong central bank support for robust liquidity is clear and makes intuitive sense given the gravity of our recent economic upheaval. We think inflationary concerns are presently well-balanced by disinflationary pressures (including high unemployment and even higher under employment).
Longer term we see an increase in shorter-term rates being part of—and reflective of—a systemic recovery. This would also imply an improvement in credit quality.
It is also worth noting that increases in short-term rates do not necessarily mean increases in long-term rates as shown in our example in Figure 1. A rise in short-term rates might, in fact, be well received by longer-term bond investors as a pre-emptive inflation fighting measure.
REIT PREFERRED STOCKS. We think real estate preferred stocks represent a compelling value given their overall risk profile and their high current yields. With market pricing indicating that spreads over the 10-Year U.S. Treasury index are 64 bps—or 17%—above the pre-crisis average spread (while also noting that the current gross spread is approximately 430 bps, 64 bps over the long-term pre-crisis average)3, we feel these securities offer potential price improvement as well as an attractive cash yield. We think a modest rise in long-term rates would likely be offset by improved credit quality and therefore remain quite constructive on the space for our income-focused accounts.
REIT COMMON STOCKS. We believe REIT common stocks are very well positioned to perform in an environment where long-term rates may move up in a stable fashion. REITs generally do an excellent job of managing the maturity of their long-term liabilities and the breadth and diversity of their leases and underlying tenant credit provide for growing income and dividends to shareholders.
Investors have a wide range of real estate securities from which to choose. REITs may issue common stock, preferred stock and debt securities. Each company may invest in distinct property sectors or geographic regions and employ varying business strategies. Investors need to be skilled in identifying the best risk-adjusted returns among the available options at any point in the business cycle.
We believe the historical performance of real estate securities, in addition to credit quality and yield spreads, provides some comfort that these securities warrant a position in investor portfolios. The key for investorsedule is to allocate for the right reasons—as a long-term investment designed to provide a combination of current yield and growth potential through changing business environments.
(c) Forward Management
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