Right now, increasingly many investors are running away from REITs (VNQ) and it has caused them to drop by over 15%:
Most of them are running away from REITs because of one main reason: they fear that rising interest rates will cause REITs to underperform going forward.
The common narrative that you often read online is that REITs should do poorly in a rising rate environment because landlords use a lot of debt to finance their properties and higher interest expenses should lower their profitability. Moreover, rising interest rates could also cause cap rates to expand, which lowers the value of their properties:
Example: A property generating $100,000 of annual net operating income is worth $2,000,000 at a 5% cap rate, but if the cap rate expands to 6% due to higher interest rates, the property will be worth just $1,666,667.
And understandably, investors are scared since the Fed just hiked rates by 50 basis points, the biggest rate hike in decades, and signaled strong commitment for more similar rates hikes later this year.
If we get several 50 basis point rate hikes, the fear is that REITs will crash further, and therefore, you better get out of them before it is too late.
But before you do something that you might regret later, I want to warn you that this common narrative is actually wrong.
Historically, REITs have actually been strong outperformers during most times of rising interest rates. On average, they have generated a 17% return in the twelve months following a rate hike in the past. This is nearly 2x better than the performance of the S&P 500 (SPY):
If rising rates are supposed to lower REIT property values and profitability, how come they've been so profitable during past cycles of rising rates?
As is often the case, investors are too quick to jump to conclusions and ignore that the impact of rising interest rates on REITs is much more complex than it may first seem.
Below, we present the three main reasons why REITs have historically done well during times of rising interest rates and why we don't expect this time to be any different:
Reason #1: Interest Rates Are The Result of Inflation
Typically, interest rates are hiked because of a growing economy and/or inflation, both of which are very beneficial for REITs.
Today, inflation is at its highest level in 40+ years and we are hiking rates to get it back under control. The last reading was over 8%:
REITs own real assets that tend to appreciate in the long run at a rate that's at least equal, but typically greater than the rate of inflation.
While you can always print more dollars, you cannot print more properties. As construction costs go up, so does the replacement value of existing assets.
Today, there aren't sufficient new constructions in many property sectors (e.g., housing) due to the high inflation, which makes it riskier to develop new properties. As a result, rents are also rising the fastest in 15 years with double-digit annual rent hikes becoming the norm.
So yes, cap rates could in theory expand a bit to maintain the spread between cap rates and interest rates, but this ignores that rents and replacement values are rising due to inflation.
Moreover, during times of high inflation, the demand for inflation-hedging assets tends to increase as investors want to protect themselves. Therefore, they are likely to accept lower spreads over their cost of capital to get this protection.
For these reasons, property values may still continue to rise even in a rising rate environment. I sure wouldn't expect prices of real assets to crash in a world of 8%+ inflation and very low interest rates. Remember that despite several 50 basis point hikes, interest rates will still remain very low and deeply negative in real terms.
Reason #2: REITs’ Balance Sheets Are Stronger Than Ever
It is a misconception that REITs use a lot of leverage. This may have been true before the great financial crisis, but REITs learned their lesson since then.
Today, REIT balance sheets are the strongest they have ever been. Leverage is low and importantly, most of this debt is fixed rate and has long maturities.
Therefore, the impact of rising rates really isn't significant on REITs.
In most cases, there is no impact at all for many years to come, and by then, interest rates may have dropped again.
In any case, the negative impact of rising rates is much lower than the positive impact of high inflation, which increases rents and property values. This is why REITs do so well in times of rising rates / inflation.
Reason #3: Sell The Rumor... Buy The News
Today, REIT share prices are 20% cheaper than they were just a few months ago. On average, REITs are today priced at a lower level than prior to the pandemic, which started over two years ago, and we all know that real estate has experienced significant appreciation since then:
The market has sold off in anticipation of rate hikes, or put differently, it has "sold the news".
This positions REITs for a strong recovery as the market eventually recognizes that the positive impact of high inflation outweighs the negative impact of rate hikes. Rents are growing rapidly, but interest expenses won't change materially or at all.
This makes REITs particularly attractive as we go into this cycle of rising rates. They are historically cheap, which provides a margin of safety, and further upside potential going forward.
A Few Top Picks
The broader REIT market may have dropped by 20%, but some individual REITs have dropped by even more than that and are now particularly opportunistic.
NewLake Capital Partners (OTCQX:NLCP) is a new Cannabis REIT that's on a path to rapid growth. It has increased its dividend every quarter since going public and still hasn't even allocated all of its IPO proceeds. We believe that it is on a path to ~8% annual FFO per share growth, but you can currently buy it at a near 7% dividend yield. Historically, it has traded at closer to a 4% yield, but the recent 33% dip has caused it to become deeply undervalued.
Medical Properties Trust (MPW) is the largest hospital REIT in the world. Its business is recession-resistant because people need to visit hospitals regardless, and its cash flow is inflation-resistant because it has long 15+ year leases with annual rent hikes and CPI adjustments. Therefore, the high inflation should benefit MPW as it accelerates its organic growth and also inflates away its fixed-rate long-term debt. Despite that, it is down nearly 20%, priced at just 12.5x cash flow, and pays a 6.3% dividend yield. If it can achieve just 3-4% annual growth, investors will earn 10%+ annual total returns from a relatively safe business.
These are just two examples among many others that we are accumulating at High Yield Landlord.
Bottom Line
My warning to you is to not panic.
Now is not the time to sell REITs.
Now is the time to buy REITs.
The market misunderstands the impact of rising rates and as a result, REITs have now become steeply undervalued.
We are accumulating them at High Yield Landlord and expect substantial gains in the coming years as REITs recover and while we wait, we earn an average 6% dividend yield.
What Are We Buying?
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If REITs had weak balance sheets, high debt levels, low interest coverage, short debt maturities, or ample floating rate loans, then the potential for corporate bond yields to spike during a recession could present grave danger.
If REITs had weak balance sheets, high debt levels, low interest coverage, short debt maturities, or ample floating rate loans, then the potential for corporate bond yields to spike during a recession could present grave danger.
Compared to other investments such as stocks and bonds, REITs are subject to various risk factors that affect the investor's returns. Some of the main risk factors associated with REITs include leverage risk, liquidity risk, and market risk.
To qualify as a REIT, a company must have the bulk of its assets and income connected to real estate investment and must distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends.
At least 75 percent of a REIT's gross income must be derived from rents from real property, interest on obligations secured by mortgages on real property, dividends from other REITs, and gain from the sale or other disposition of real property.
Summary of Why Investors May Not Want to Invest in REITs
But, REITs are not risk free. They may have highly variable returns, are sensitive to changes in interest rates, have income tax implications, may not be liquid, and fees can impact total returns.
The FTSE Nareit All Equity index, consisting of REITs that exclude mortgages, generated a 15.9% annualized return during recessions and 22.7% in the year following the end of a downturn, according to the National Association of Real Estate Investment Trusts.
REITs don't have to pay a corporate tax, but the downside is that REIT dividends are typically taxed at a higher rate than other investments. Oftentimes, dividends are taxed at the same rate as long-term capital gains, which for many people, is generally lower than the rate at which their regular income is taxed.
Most REITs are less volatile than the S&P 500, with some only half as volatile as the market at large. The self-storage REIT subgroup shows the highest returns, with annualized returns of 18.8% from 1994 to 2021.
A REIT will be closely held if more than 50 percent of the value of its outstanding stock is owned directly or indirectly by or for five or fewer individuals at any point during the last half of the taxable year. This is commonly referred to as the 5/50 Test.
The total expenditures made by the REIT, or any of its partners, during the two years preceding the sale of the land may not exceed 30 percent of the net selling price of the property (IRC § 857(b)(6)(C)(ii) ).
For each tax year, the REIT must derive: at least 75 percent of its gross income from real property-related sources; and. at least 95 percent of its gross income from real property-related sources, dividends, interest, securities, and certain mineral royalty income.
80-20 Rule: At least 80% of a REIT's asset value must be in completed and income-generating real estate, with the remaining 20% able to be invested in riskier assets such as under construction buildings, equity shares, bonds, cash, or under-construction commercial property.
The lockout rule provides that subject to some exceptions, if the REIT election of a corporation (the former REIT) has been terminated or revoked for any tax year (the termination year),27 the former REIT will be ineligible to reelect REIT status for the four tax years following the termination year (the lockout period ...
Since the initial investment is not guaranteed, you could lose all your money. A REIT is not a fixed income investment. A rise in interest rates can reduce the value of the units, as investors can then choose other more profitable investments.
Strong REIT balance sheets put the sector in a strong position to deploy capital in 2023, bankers told REIT.com. Meanwhile, REIT debt and equity issuance is expected to improve, and IPO activity, along with an uptick in mergers and acquisitions (M&A), is also a possibility later in the year, they say.
The REIT sector started strong in 2023 with an +11.77% total return in January, but quickly gave up the majority of those gains in February with a disappointing -6.18% return in February. REITs underperformed the Dow Jones Industrial Average (-3.9%), S&P 500 (-2.4%) and NASDAQ (-1.0%).
Put differently, it is offered at 60 cents on the dollar relative to the value of its assets. Billionaires like the idea of buying real estate at cents on the dollar and this is why they are loading up on REITs at the moment. John Gray, COO of Blackstone said on a conference call in 2022 that (emphasis added):
After looking at correlation patterns and historical data, it appears that returns from REITs vary during different interest rate periods, but for the most part have shown a positive correlation during increasing interest rates.
As interest rates rise, they can depress the price of these REITs. So while dividends may climb with interest rates, the price of publicly-traded REITs may decline. Historically, REITs are one of the better-performing sectors during inflationary periods.
Since the value of a mortgage bond trades inversely to interest rates (higher rates cause mortgage bond values to decline), higher rates will mean that the NAV of a mortgage REIT will decline and often take the share price with it.
Camden Property, Prologis, and Realty Income have some of the safest dividends in the REIT industry. All three companies have top-tier financial profiles, enabling them to sustain their dividends even during tough times. They're great options for investors seeking rock-solid passive income streams.
Why should I invest in REITs? REITs are total return investments. They typically provide high dividends plus the potential for moderate, long-term capital appreciation. Long-term total returns of REIT stocks tend to be similar to those of value stocks and more than the returns of lower risk bonds.
Bad REIT Income means (i) the amount of gross income received by the Borrower (directly or indirectly) that would not constitute (A) “rents from real property” as defined in Section 856 of the Internal Revenue Code or (B) interest, dividends, gain from sales or other types of income, in each case, described in Section ...
When investing in a REIT, the maximum loss is the total invested amount. The two ways an investor can benefit from an investment in a REIT are the regular income distributions and a potential price increase. Generally speaking, returns on REITs are from dividends rather than price appreciation.
In general, a good rule of thumb is that REITs should not make up more than 25% of a well-diversified dividend stock portfolio, depending on your individual goals (such as what portfolio yield and long-term dividend growth rate you're targeting, and how much volatility you can stomach).
More importantly, real estate remains a wealth-building tool for the majority of moguls. An estimated ninety percent of millionaires were created through real estate investing. Any billionaire in the U.S. or anywhere around the globe that you know of has invested in real estate in some form or the other.
There is a prohibited transaction safe harbor if a REIT sells fewer than 7 properties in a year and holds each property for more than 2 years. All potential sales transactions should be reviewed in order to consider potential issues. If a transaction is determined to be prohibited, then there is a 100% tax on the gain.
Invest at least 75% of its total assets in real estate. Derive at least 75% of its gross income from rents from real property, interest on mortgages financing real property or from sales of real estate. Pay at least 90% of its taxable income in the form of shareholder dividends each year.
Return a minimum of 90% of taxable income in the form of shareholder dividends each year. This is a big draw for investor interest in REITs. Invest at least 75% of total assets in real estate or cash.
These REITs trade on a stock exchange, such as the Nasdaq or the New York Stock Exchange (NYSE). They're highly liquid – meaning they can be bought or sold at any time so your money isn't tied up – and are open to all types of investors.
While a REIT is still open to public investors, investors may be able to sell their shares back to the REIT. However, this sale usually comes at a discount; leaving only about 70% to 95% of the original value. Once a REIT is closed to the public, REIT companies may not offer early redemptions.
If the taxpayer wants to identify more than three properties, he can use the 200% rule. This rule says that the taxpayer can identify any replacement properties as long as the aggregate fair market value of what he identifies is not greater than 200% of the fair market value of what was sold as relinquished property.
A REIT must have at least 100 shareholders (the “100 shareholder test”) for at least 335 days of a 12-month taxable year or during a proportionate part of a taxable year that is less than 12 months. The days need not be consecutive. This requirement does not apply until the REIT's second taxable year.
What Is The 1% Rule In Real Estate? The 1% rule of real estate investing measures the price of the investment property against the gross income it will generate. For a potential investment to pass the 1% rule, its monthly rent must be equal to or no less than 1% of the purchase price.
REITs can be very volatile in the short run and it will often cause investors to overreact, especially if some negative news comes out. Example: a REIT may announce that it suffered some temporary setbacks in its quarterly results and it will rapidly sell off.
While a REIT is still open to public investors, investors may be able to sell their shares back to the REIT. However, this sale usually comes at a discount; leaving only about 70% to 95% of the original value. Once a REIT is closed to the public, REIT companies may not offer early redemptions.
Are real estate stocks good investments in 2023? The answer is probably if the basis is the sector's year-to-date performance (+10.52%). Real estate investment trusts (REITs) took a beating last year due to rising interest rates. However, if you want exposure to the real estate market, evaluate the prospects carefully.
Typically, a REIT with a payout ratio between 35% and 60% is considered ideal and safe from dividend cuts, while ratios between 60% and 75% are moderately safe, and payout ratios above 75% are considered unsafe. As a payout ratio approaches 100% of earnings, it generally portends a high risk for a dividend cut.
Introduction: My name is Horacio Brakus JD, I am a lively, splendid, jolly, vivacious, vast, cheerful, agreeable person who loves writing and wants to share my knowledge and understanding with you.
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