How do rising interest rates affect REITs?

Last week, we discussed in this column that property stocks do not offer the same protection from inflation as real estate assets due to differences in risks and volatility.

Property stocks tend to fall when inflation increases because they are negatively correlated with the movements of interest rates.

Market history tells us that when interest rates go up, as a result of unexpected increases in inflation, property stocks tend to lose value in more than 60 percent of the time.

If property stocks are inversely related to interest rate risks, can we also assume the same for real estate investment trusts or REITs?

Well, there are two ways rising interest rates can possibly affect REITs.

One is by increasing borrowing costs. Higher interest rates can make acquisition costs of new assets more expensive if REITs are financing their expansion by borrowings.

If REITs are highly leveraged, higher borrowing costs can also lower their distributable income, which may lead to smaller dividend payouts and yields.

The other way is by increasing the capitalization rate or cap rate that is used by many real estate appraisers to value properties. Rising interest rates can increase the cost of capital of REITs that can lead to higher cap rates.

A high cap rate can result to lower net asset value or NAV of REITs that could pressure REIT stock prices to fall.

For example, if the current cost of capital of Filinvest REIT (FILRT) is 8.4 percent, which is derived from the current 10-year bond yield of 6.11 percent plus risk premium, we can estimate its cap rate, following a discounted cash flow method, to be at 3.24 percent.

Assuming FILRT generates a net operating income (NOI) of P1.6 billion per year, we can divide its NOI by its cap rate of 3.24 percent to derive a valuation of its investment properties at P49.2 billion.

Now if interest rates continue to go up and the 10-year bond yield goes to 7.11 percent, then FILRT’s cap rate will also increase from 3.24 percent to 4.2 percent.

Applying a higher cap rate against the same net operating income of P1.6 billion will result to a 22-percent decrease in valuation of FILRT’s investment properties, which will reflect in a lower NAV.

While rising interest rates can indeed pose serious challenges to REITs, a look at historical record of REIT performance in the Philippine Stock Exchange would show that they do not necessarily lead to negative returns.

If we combine the market capitalization of all listed REITs in the market and correlate its changes with the movement to 10-year bond yield since 2020, we will find that, contrary to regular property stocks, REITs are positively correlated with interest rates in 79 percent of the time.

This strong correlation means that REITs in the long run tend to move in the same direction with interest rates, because REITs adjust their rental rates upwards along with inflation over time.

If we will look at the current REITs in the market today, we will find that almost all of them have contractual rental escalation rates of 5 to 10 percent per year.

The annual escalation rates enable REITs to grow their income through the years, which results to higher dividend growth and share price appreciation.

The rise in interest rates this year, which saw the 10-year bond yield increasing from 4.7 percent in January this year to 6.1 percent has caused REIT prices to correct, resulting to higher average dividend yields from 5.2 percent to 5.6 percent.

Rising interest rates can make REITs’ dividend yields less attractive in the short-term because of the higher returns offered by less risky fixed income securities.

If the average dividend yields were to catch up with the current 10-year bond yield at 6.1 percent, REIT share prices could fall further by an average of 6.4 percent in the coming weeks.

But the current weakness in REIT prices should offer good opportunity to lock in higher dividend yields with the prospect of strong capital appreciation in the long-term.

Unlike the typical property stocks, REITs can perform well in a rising-rate environment, generating cash flow stream that can grow over time and providing protection that real estate assets provide. INQ

Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend the 95th batch of RFP program this May 2022. To register, email [email protected] or text at 0917-6248110