Are REITs A Good Investment When Interest Rates Rise?

When interest rates climb, investors flee to any excellent asset they can find for protection. Depending on the market cycle, alternative investments such as real estate investment trusts (REITs) can be a suitable option. Let’s take a look at how REITs fared in periods of high and low interest rates.

Do REITs do well when interest rates rise?

“How did REITs do during the last time of rising interest rates?” asks Matt Frankel. When all else is equal, REITs are extremely sensitive to interest rates. The majority of dividend stocks are. When I say interest rates, I’m usually talking to treasury rates, such as the 10-year Treasury yield, which is an excellent benchmark to know.

In general, as that rate rises, REITs fall in value. The reason for this is that income investors expect a risk premium over what they can get from a risk-free investment like a treasury bond. For example, if a 10-year Treasury yields 2%, a REIT might yield 5%. If the 10-year Treasury yield jumps a percentage to 3%, investors will expect a similar percentage jump in their REIT dividend yield. Because the relationship between dividend yield and stock price is inverse, rising rates lead to higher dividend yields, which in turn leads to lower stock prices. That is, assuming everything else is equal. Everything isn’t always equal. Interest rates fell during the COVID epidemic, which would have been beneficial to REITs in a normal environment, but real estate was one of the hardest-hit sectors when the pandemic began. There are many other forces at work, and they aren’t all related to interest rates. Interest rates rising are negative for REITs in a regular, boring stock market, whereas interest rates falling are favorable for REITs.

To respond to Ryan’s question more directly, during the most recent period of rising interest rates, which was roughly from 2018 to 2019, REITs underperformed severely, and real estate was one of the worst-performing sectors in the market at that time. It still rose, but tech companies outperformed it, and it underperformed the S&P 500 by a small margin.

If you’re a REIT investor, keep in mind that it tends to even out over time. They do worse when rates rise and better when rates decrease, and because these are long-term investments, it tends to even out over time.

Why are high interest rates bad for REITs?

REITs must therefore raise external debt and equity money from investors in order to grow. As a result, higher interest rates raise the cost of debt for REITs, making it more difficult to achieve profitable expansion.

Are REITs good during inflation?

In the 1970s, the same three acts were taken. Everyone understands that rising oil prices and the federal government’s reckless financial maneuvering were to blame.

Despite the government’s enhanced social programs, inflation stayed at only 1.1 percent in the early 1960s. However, in 1965, the Vietnam War broke out, and increased demand for industrial goods drove up prices.

Consumers had greater spending money in 1969, when consumer price inflation had risen to more than 5%.

The same can be said of government attitudes in the two periods. In fact, it’s possible that this is the most important comparison.

In her article, Kathy Jones expands on this “Is 1970s Style Inflation Making a Comeback?” from Charles Schwab:

Today, the Fed, like in the 1970s, is deciding whether or not to allow inflation to rise. After a thorough examination of its actions over the past few decades, it came to the conclusion that it had placed too much emphasis on inflation, which had stifled economic growth and kept down job growth and salaries for many workers. Before the Covid-19 crisis, it was the case. Faced with the pandemic’s deflationary effects, the Fed now believes it has room to err on the side of being too easy for too long.

However, we are not entirely reliving history at this time. As I’ll demonstrate further down, history never repeats itself word for word.

As Scott Horsley points out in his article, “Do You Think Inflation Is a Problem Right Now? NPR’s “Let’s Take a Step Back to the 1970s”:

Treasury Secretary Janet Yellen and others in the administration say that the present price increase is a one-time occurrence caused by supply shocks related to the pandemic and pent-up consumer demand.

The mentality of today’s America, though, is a significant and distinct difference. In the 1970s, the general population in the United States believed that inflation was unavoidable. However, not everyone is now so negative.

People will be more willing to accept lower salary increases if they feel prices will remain relatively stable. People who sell products will not demand large price rises. Once that psychology has taken hold, it has a tendency to repeat itself.

Alan Blinder, an economist who served as the Federal Reserve’s vice chairman in the 1990s, agrees with this assessment:

If you’re a business and expect inflation to be 5%, your prices will almost certainly go up 5% when it’s time to set them for the next year. On the other hand, if you believe inflation will be 1%, you’re more likely to increase by 1%.

Whether those predictions prove to be correct or entirely incorrect will be determined by the passage of time. For the time being, however, we do have options for dealing with the current and even future situations, whatever they may be.

Investors, understandably, hope that the current round of inflation isn’t a one-time occurrence. And it’s possible that it will be.

Regardless of whether we see a speedy rebound or continued inflation, REITs remain a strong investment option.

Regardless, “While “inflation” may appear to be a nasty term, a small amount of it can be beneficial to the economy. And a lot of money doesn’t always kill certain industries, particularly REITs.

After all, the value of real estate tends to rise in tandem with the value of consumer items. Cohen & Steers, a worldwide investment manager, explains this in their report “Three Inflation-Resilient Portfolio Building Strategies”:

1st “Higher prices for labor, land, and construction supplies might raise the economic threshold for new development, therefore property values tend to rise with the general pricing environment. As a result, new supply may be constrained, encouraging higher occupancies and allowing landlords more flexibility to raise rents.”

2. Inventive+ phrasing “Hotels, self-storage, apartments, senior housing, and billboards, among other property types with shorter lease terms, might benefit from rising rents quite quickly.”

3. If you’re looking for a “Many commercial leases, particularly outside the United States, include explicit inflation linkages, with rent escalators related to a publicized inflation rate.”

REIT dividends tend to grow faster than inflation as a result of these variables, as detailed in the same article:

We expect REITs to produce above-average dividend growth over the next three years, similar to what we witnessed post-2009, following pandemic-driven dividend reduction in 2020. Despite the fact that the pandemic has hastened changes in how real estate is used (some for the better, others for the worst), we believe REITs’ ability to grow rents faster than inflation remains unaltered.

At the risk of seeming repetitious, I really want to emphasize this: REITs provide investors with some inflation protection because real estate rental rates rise in lockstep with the price of goods and services. As I recently stated in an essay, “How to Think About Inflation Like a REIT”:

Overall, REITs are well-positioned to gain from rising inflation while also delivering appealing current income streams that should rise over time.

Whether inflation rises or falls as a result of unexpected pandemic-related issues, REITs provide investors with reliable income streams. That’s why, happily, I’m sticking with them.

Why are REITs a bad investment?

Real estate investment trusts (REITs) are not for everyone. This is the section for you if you’re wondering why REITs are a bad investment for you.

The major disadvantage of REITs is that they don’t provide much in the way of capital appreciation. This is because REITs must return 90 percent of their taxable income to investors, limiting their capacity to reinvest in properties to increase their value or acquire new holdings.

Another disadvantage is that REITs have very expensive management and transaction costs due to their structure.

REITs have also become increasingly connected with the larger stock market over time. As a result, one of the previous advantages has faded in value as your portfolio becomes more vulnerable to market fluctuations.

Weak Growth

REITs that are publicly listed are required to pay out 90% of their profits in dividends to shareholders right away. This leaves little money to expand the portfolio by purchasing additional properties, which is what drives appreciation.

Private REITs are a good option if you enjoy the idea of REITs but want to get more than just dividends.

No Control Over Returns or Performance

Investors in direct real estate have a lot of control over their profits. They can identify properties with high cash flow, actively promote vacant rentals to renters, properly screen all applications, and use other property management best practices.

Investors in REITs, on the other hand, can only sell their shares if they are unhappy with the company’s performance. Some private REITs won’t even be able to do that, at least for the first several years.

Yield Taxed as Regular Income

Dividends are taxed at the (higher) regular income tax rate, despite the fact that profits on investments held longer than a year are taxed at the lower capital gains tax rate.

And because REITs provide a large portion of their returns in the form of dividends, investors may face a greater tax bill than they would with more appreciation-oriented assets.

Potential for High Risk and Fees

Just because an investment is regulated by the SEC does not mean it is low-risk. Before investing, do your homework and think about all aspects of the real estate market, including property valuations, interest rates, debt, geography, and changing tax regulations.

Fees should also be factored into the due diligence process. High management and transaction fees are charged by some REITs, resulting in smaller returns to shareholders. Those fees are frequently buried in the fine print of investment offerings, so be prepared to dig through the fine print to find out what they pay themselves for property management, acquisition fees, and so on.

Do REITs lose money?

  • REITs (real estate investment trusts) are common financial entities that pay dividends to their shareholders.
  • One disadvantage of non-traded REITs (those that aren’t traded on a stock exchange) is that investors may find it difficult to investigate them.
  • Investors find it difficult to sell non-traded REITs because they have low liquidity.
  • When interest rates rise, investment capital often flows into bonds, putting publically traded REITs at danger of losing value.

Are REITs good for retirement income?

Nareit commissioned Wilshire Funds Management to investigate the function of REITs in Target Date Funds (TDFs). REITs, according to Wilshire, play a crucial role in boosting investment returns and lowering risk in these popular investment vehicles.

Individuals can use TDFs to make portfolio planning easier. Over the next few decades, it is predicted that the bulk of new 401(k) and IRA assets will be put in TDFs, and millions of Americans’ retirement security will be dependent on their investment performance.

REITs Important Across the Target Date Fund Lifecycle

For workers with various retirement horizons, the figure below highlights the recommended proportion of US REITs in a retirement portfolio.

  • REIT allocations range from 15.3 percent of a young worker’s portfolio with 40 years till retirement to over 10% for an investor nearing retirement age.
  • The REIT allocation drops with other equities throughout retirement, but it still exceeds 6% for an investor nearly ten years later.

REIT Attributes: High and Stable Income, Long-term Capital Appreciation, Diversification and Inflation Protection

Because they provide income, capital appreciation, diversification, and inflation protection, REITs are a significant aspect of retirement portfolios.

Adding assets with low correlations to the current assets in the portfolio can reduce portfolio volatility. The long-term correlations of equity REITs with the other major asset classes studied range from 0.19 to 0.65, indicating that adding REITs to an investing portfolio can provide diversification benefits.

Table 1 compares asset allocations for an optimal portfolio in the glide path for the 15-year-to-retirement cohort, excluding and incorporating REITs in the set of possible investments.

U.S. TIPS, U.S. High Yield Bonds, and U.S. Small Cap Equities have much lower or nil allocations in the REIT-based portfolio. REITs are a more efficient asset class for combining the investing features of high and consistent income, long-term capital appreciation, and inflation protection since they take “shelf space” in the optimal allocation from these assets.

REITS Improve Retirement Readiness

Incorporating REITs into the TDF portfolio boosts returns while lowering risk. Over the 44-year period 1975 to 2019, Table 2 compares risk and return for optimal portfolios in the middle of the glide path, excluding and incorporating REITs. A TDF portfolio that includes REITs has a higher return and lower risk than one that does not. With an average portfolio risk of 9.33 percent, the TDF REIT portfolio returned 10.49 percent annually. Without REITs, the return would be 10.02 percent and the annualized portfolio risk would be 9.50 percent. The TDF portfolio utilizing Surplus Optimization would have had a portfolio value at the end of 2019 that was 20.4 percent greater than a portfolio without REITs during the 44-year investing period.

*The Wilshire study detailed on this page is an updated version of a 2012 Wilshire study.

How often do REITs fail?

Historically, buying REITs following a market crisis has always been a smart move, and we have little doubt that this time will be no different. REITs, on the other hand, aren’t “ideal investments.” In truth, there are numerous ways for a REIT investor to lose money. Over the last 20 years, REITs have returned 15% a year, according to NAREIT.

Are REITs a good investment now?

The best real estate investment trusts (REITs) are those that can provide investors with market-beating total returns, which are made up of dividend yield and stock price gain as their market capitalization rises. To achieve those gains, a REIT must be able to boost its dividend by growing the income generated by its real estate assets. An income investor can buy three top REITs with outsized upside potential this month.

Are REITs a good hedge against stocks?

REITs are a cross between mutual funds and real estate investment trusts. Although they trade like stocks, their dividend yields can be comparable to trash bonds. I purchased two of them in late March—Starwood Property Trust (symbol STWD) and Apollo Commercial Real Estate Finance (ARI)—because I believe REITs should be part of every well-diversified portfolio. REITs offer stock market returns, but they don’t always move in lockstep with the market. As a result, holding REITs can help you diversify your portfolio without sacrificing profits. Even better, REITs are a solid inflation hedge because rents and real estate values tend to rise in tandem with rising prices.

What percentage of your portfolio should be in REITs?

Despite the fact that REITs trade on major stock exchanges, many financial planners (including myself) consider real estate to be a separate asset class from stocks and bonds. As a general guideline, allocating 5 percent to 10% of your assets to REITs is an excellent approach to diversify your exposure and/or improve your portfolio’s dividend income.

Of course, this is just a starting point; in some cases, the optimum answer for you may be substantially higher. REITs, for example, account for around 30% of my stock portfolio. It’s wise to invest in what you know, as many prominent investors have said. Real estate is the sector in which I am most comfortable appraising, thus it accounts for the majority of my portfolio’s allocation.

For income-seeking investors, REITs could be a solid choice for more than 10% of a stock portfolio. Let’s face it: today’s bond and other fixed-income investment yields aren’t exactly stellar. However, there are a slew of REITs with dividend yields in the 3% to 4% range that are completely sustainable. As a result, a retiree or other income-oriented investor might benefit from a bigger REIT investment.