How Do Rising Interest Rates Affect REITs?
What Is a Real Estate Investment Trust?
Not all stocks are created equal; some perform better than others during periods of rising interest rates and high inflation.
In 2022, the stock market had a terrible year, with the S&P 500 in a correction and the Nasdaq deep in a bear market. Most of that can be blamed on unprecedented interest rate hikes. As of this writing, the Federal Reserve has raised its key interest rate six times in 2022, from 0.5% to a range of 3.75% to 4.0%, the highest it has been since early 2008. The Fed has been raising its key rate in an effort to get a handle on decades-high inflation.
Rising interest rates might be good for curbing inflation, but they’re bad for stock prices. That’s because higher rates increase the cost of capital, which deters businesses from expanding. Rising interest rates also cause companies’ earnings growth to deteriorate.
Rising interest rates aren’t bad for all equities, though. For instance, real estate investment trusts (REITs) often perform well during periods of high interest rates and inflation. REITs finance or own income-producing real estate in a wide range of property sectors. There are two main types of REITs: equity and mortgage.
What Are Some Examples of Equity REITs?
Equity REITs generate income from renting out or selling properties. There are as many different types of equity REITs as there are property types.
Industrial REITs own, develop, and lease out properties such as warehouses, fulfillment centers, and data centers. Prologis, Inc. (NYSE:PLD) is the largest industrial REIT. The company has owned or had investments in approximately 1.0 billion square feet of real estate in 19 countries. It has leased its properties to 5,800 tenants, principally in two major business categories: business-to-business and retail/online fulfillment.
Hotel & Resort
Two of the leading hotel and resort REITs are Ryman Hospitality Properties Inc (NYSE:RHP) and Apple Hospitality REIT Inc (NYSE:APLE). Ryman specializes in “upscale convention center resorts and country music entertainment experiences.” Apple Hospitality has one of the biggest portfolios of upscale hotels in the U.S.
Office REITs focus on properties in locations ranging from the suburbs to the largest cities. SL Green Realty Corp (NYSE:SLG) is New York City’s biggest office landlord, having interests in 64 buildings totaling 34.4 million square feet. Alexandria Real Estate Equities Inc (NYSE:ARE) specializes in offices for the collaborative life sciences, agricultural technology (AgTech), and technology sectors. Office Properties Income Trust (NASDAQ:OPI) owns and primarily leases office properties to single tenants. Its biggest client is the U.S. federal government.
Health-care REITs specialize in hospitals, nursing homes, and assisted living facilities.
Sabra Health Care REIT Inc (NASDAQ:SBRA) has 416 investments: 279 skilled nursing/transitional care facilities, 59 leased senior housing properties, 50 managed senior housing facilities, 13 behavioral health centers, and 15 specialty hospitals and “other” properties.
Omega Healthcare Investors (NYSE:OHI) is a triple-net equity REIT with 921 senior care centers, skilled nursing facilities, and assisted living facilities in 42 U.S. states and the U.K.
Retail REITs acquire, develop, lease out, and manage retail properties such as shopping centers and outlet malls.
National Retail Properties, Inc. (NYSE:NNN) owns 34.3 million square feet of real estate in 48 states. Those properties are leased to more than 380 tenants, including 7-Eleven Inc., Dave & Buster’s Entertainment Inc (NASDAQ:PLAY), Mister Car Wash (NYSE:MCW), and Sunoco LP (NYSE:SUN).
Getty Realty Corp. (NYSE:GTY) specializes in properties such as convenience stores, gas stations, car washes, auto service stations, and auto part retailers. The company has 1,021 properties in 38 U.S. states and D.C.
Residential REITs buy and lease out multifamily homes, apartments, manufactured dwellings (i.e., modular and mobile homes), and student housing. Camden Property Trust (NYSE:CPT) is one of the largest publicly traded multifamily housing companies in the U.S. It owns and operates 171 properties containing 58,433 apartments across the country. Mid-America Apartment Communities Inc (NYSE:MAA) has an ownership interests in 101,769 apartments (including some in communities under development) in 16 states and D.C.
Diversified REITs have operations in two or more property types, like commercial and residential.
VICI Properties Inc (NYSE:VICI) is one of the largest owners of gaming, hospitality, and entertainment destinations in the U.S. Its properties include Caesars Palace Las Vegas, Mandalay Bay, The Mirage, and the Venetian Resort Las Vegas.
Necessity Retail REIT Inc (NASDAQ:RTL) owns 1,057 properties covering more than 29.3 million rentable square feet in 48 states. The company’s top tenants include Burger King Corporation, Dollar General Corp (NYSE:DG), Domino’s Pizza Inc (NYSE:DPZ), Exxon Mobil Corp (NYSE:XOM), Home Depot Inc (NYSE:HD), and PetSmart, LLC.
Specialized REITs don’t fit into any of the above-mentioned categories. They don’t generate the majority of their income from real estate rental or leasing operations.
American Tower Corp (NYSE:AMT), one of the largest global REITs, has approximately 223,000 communication sites in 25 countries on six continents. This includes more than 43,000 properties in the U.S. and Canada.
Iron Mountain Inc (NYSE:IRM) is the global leader in storage, asset lifecycle management, and information management services. The company has more than 225,000 customers worldwide (including 95% of the Fortune 1000 companies). It has 1,380 facilities in 63 countries. They cover 95 million square feet (730 million cubic feet of physical volume)—the equivalent of 1,650 NFL football fields.
What Are Some Examples of Mortgage REITs?
Mortgage REITs (mREITs) invest in mortgages instead of directly in real estate. They provide financing for income-generating real estate by purchasing or originating mortgages and mortgage-backed securities (MBSs), earning income from the interest on those investments.
Dynex Capital Inc (NYSE:DX) invests in residential MBSs (RMBSs) and commercial MBSs (CMBSs), including interest-only CMBSs.
Ellington Residential Mortgage REIT (NYSE:EARN) acquires, invests in, and manages residential mortgage and real estate-related assets. The company mainly focuses on RMBSs, specifically those backed by a U.S. government agency or a U.S. government-sponsored enterprise.
ARMOUR Residential REIT, Inc. (NYSE:ARR) invests in RMBSs that are issued or guaranteed by a U.S. government-sponsored enterprise.
How Do REITs Perform When Interest Rates Rise?
Investors looking for protection from soaring interest rates and inflation should take a close look at REITs. Despite fears that REITs underperform when interest rates are high, they’ve actually done well in times of high interest rates and inflation. One reason is that REITs can pass on their additional costs to their tenants through increased rents. Moreover, to maintain their status as REITs, the companies are legally required to pay at least 90% of their taxable income to their shareholders as dividends.
Not all REITs are the same, though. They might be able to increase their rents, but their underlying operations can be hit differently by economic headwinds. For instance, during the COVID-19 pandemic, restaurants and brick-and-mortar retailers took a big financial hit, leading rent delinquencies to soar. Meanwhile, health-care REITs, especially those with nursing homes, saw their share prices tumble in the past few years due to the optics regarding the spread of COVID-19 in those types of facilities.
That said, many retail REITs, especially those with longer-term leases—like those at shopping centers and outlet malls—have annual rent increases built into their contracts. The rent increases are generally tied to the consumer price index (inflation) but often have upper limits. This can, at times, result in inflation outpacing the built-in rent increases. REITs don’t put all their eggs in one basket, though, and usually, a portion of their leases are renegotiated each year.
Other types of REITs can respond more quickly to inflationary pressures. Storage facilities can set their rental rates monthly, weekly, or even daily. Hotels can increase their room prices, and apartment building can boost their rents as tenants turn over.
Furthermore, when inflation is high, the demand for real estate is also high, which leads to hotter property values. It’s not uncommon for a REIT to sell some of its properties when real estate prices are high. And again, because of legal reasons, a REIT has to pass on most of its taxable income to investors, which can result in frothy special dividends.
For all these reasons, even in a high-inflation environment, REITs generate a steady income stream. This helps them pay reliable, high-yield dividends.
How Do mREITs Perform When Interest Rates Rise?
Some REITs are more sensitive to interest rate changes than others. During the rising-interest-rate period of 1972 to 2013, equity REIT stocks returned 9.8% annually, while mREIT stocks lost 4.1% in value per year.
An mREIT makes money on its net interest margin, which is the spread between its funding costs and its interest income. This can make mREITs riskier than other investments, including equity REITs. Therefore, mREITs are highly susceptible to rising interest rates. When interest rates rise, the short-term borrowing rates that mREITs pay go up, but the interest they collect on the mortgages they own stays the same. This cuts into their profits and taxable income.
What about when interest rates fall? In a fixed-rate environment, borrowers pre-pay their mortgages. They can also refinance their loans or sell their real estate. When this happens, mREITs need to reinvest their repaid loans at the current interest rate, which could be lower than the rate they were charging on the mortgages.
An mREIT can also face credit risks if a borrower defaults. mREITs that focus on residential loans that are backed by government agencies like the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), or the Government National Mortgage Administration (Ginnie Mae) don’t need to worry as much.
mREITs generally own long-term mortgages and MBSs. They can fund these purchases with short-term borrowing because the short-term interest rates are generally lower than the long-term interest rates. When the loans mature, the mREIT needs to obtain funding at an attractive interest rate to roll over the loan.
Despite the risks, mREITs can generate significant amounts of cash when there’s a big spread between short-term interest rates (at which they borrow) and long-term interest rates (at which they lend). If that spread shrinks, their cash flow can shrink, too. This is why dividends from mREITs can be so volatile.
Why Do Investors Love REITs?
Investors love REITs because they generate revenues through their properties and mortgages and, as noted above, distribute at least 90% of their taxable income to their shareholders in the form of dividends. This usually translates into growing, ultra-high-yield dividends. Whereas the dividend yield on the S&P 500 is a paltry 1.6% and the yield on a 10-year Treasury note is 3.7%, the dividend yield on a REIT can easily hit double-digits.
The following REITs have some of the highest dividend yields (as of this writing).
|Company Name||Stock Ticker||Dividend Yield|
|SL Green Realty Corp||NYSE:SLG||9.0%|
|Omega Healthcare Investors Inc||NYSE: OHI||9.1%|
|Dynex Capital Inc||NYSE:DX||12.2%|
|Necessity Retail REIT Inc||NASDAQ:RTL||13.0%|
|Office Properties Income Trust||NASDAQ: OPI||14.8%|
|Ellington Residential Mortgage REIT||NYSE:EARN||13.2%|
|ARMOUR Residential REIT, Inc.||NYSE:ARR||20.7%|
Despite ongoing volatility in the stock market, interest rates aren’t a key driver of a REIT’s medium-term and long-term performance. The more important factors are the ones that drive interest rates higher.
If interest rates go up because of economic improvements and inflationary activity, stronger equity REIT fundamentals can outweigh any negative impact of the rising rates. Even in the mREIT world, some companies have business models that allow them to perform better despite the sector’s overall volatility.
Thanks to excellent long-term total returns, high dividend yields, and increased diversification, REITs can be a great hedge against inflation. Since soaring inflation and surging interest rates can have a negative impact on stock prices, it’s wise to diversify an investment portfolio by including REIT stocks.