Are REITs Threatened By Treasury Yields, Rate Hikes?

The spotlight is once again on bond market behavior, and stocks are scrambling for an indication which way to turn. REITs, which are often treated as bonds because of their high dividend paying nature, are naturally in focus. As such, treasury yields end up playing a significant role in the price movement of REIT stocks -- yields of which become less attractive when treasury yields rise.

The global bond market has been bustling lately. Last Wednesday, yields on Germany’s 10-Year Bunds (German government bonds) crossed the 1% threshold for the first time since September, with deflationary concerns being receded by the recent economic data and anticipations of stabilization in the Euro-zone economy.

The ripple effect of the European sell-off could be felt in the U.S. Treasury market where 10-Year yields remained high amid substantial government auctions. Despite anticipations of minor corrections, the yields are further expected to move up with the Fed gearing up for a rate hike in the upcoming months according to the consensus view.

Impact on Segments

Essentially, rising interest rates lead to an increase in interest costs as REITs usually look for both fixed and variable rate debt financing to pay back maturing debt, and fund their acquisitions, development and redevelopment activities. Therefore, REITs cannot practically run away from the impact of rate hikes. But the extent of such an impact would depend on the nature of their leases and funding activities.

Take for example the Healthcare REITs that usually have significant exposure to long-term leased assets. The long-term leases carry fixed rental rates that are subject to annual bumps. But their debt obligations bear floating rates with interest and related payments rates varying with the movement of LIBOR, Bankers’ Acceptance or other indexes.

Therefore, as the rates rise, the cost of borrowing increases but their revenue flows do not get adjusted quickly for their fixed-rate nature, leading to an adverse impact on profitability.

Consider Mortgage REITs that offer real estate financing through purchase or origination of mortgages and mortgage-backed securities (MBS). These REITs fund their investments with equity and debt capital and earn profits from the spread between interest income on their mortgage assets and their funding costs.

Though these types of REITs have started adjusting their strategies and business models, these companies bear long-term risk as interest rates will eventually rise.

In fact, for the equity REITs that acquire properties such as apartments, shopping malls, office buildings and several other kinds of assets and generate income from renting them out, there are risks besides the interest rate issue. Specific market weakness can also dampen their growth momentum.

Among the equity REITs are the Apartment REITs for which elevation in the supply level in certain markets raises an alarm. This is because higher supply usually curtails the landlord’s capability to demand more rents and leads to lesser absorption.

In fact, the increase in deliveries of new units has already kept industry behemoths like AvalonBay Communities Inc (NYSE:AVB) and Equity Residential (NYSE:EQR) on their toes. AvalonBay is expected to experience an increase in supply in Seattle and Northern California. Moreover, the D.C. region remains a weak market with a reasonable amount of supply coming online.

For Equity Residential, new leasing is expected to face tremendous pressure and pricing might be adversely impacted in regions with elevated supply. Markets such as Washington D.C., Boston, Brooklyn and Jersey City and South Florida are specific areas of concern.

Even for the Hotel/Lodging REITs, though supply in the West Coast is low and overall whole fundamentals remain strong, higher supply on the East Coast and overall pricing weakness continue to restrict RevPAR (Revenue Per Available Room) growth in the region.

Specific REITs that we don't like with a Zacks Rank #5 (Strong Sell) include American Capital Mortgage Investment Corp. (NASDAQ:MTGE) and Redwood Trust, Inc. (NYSE:RWT) as well as Zacks Rank #4 (Sell) stocks such as Ellington Residential Mortgage REIT (NYSE:EARN), DDR Corp. (NYSE:DDR), Retail Properties of America, Inc. (NYSE:RPAI), American Homes 4 Rent (ASX:AMH), Independence Realty Trust, Inc. (NYSE:IRT), Gladstone Commercial Corp. (NASDAQ:GOOD), Terreno Realty Corp. (NYSE:TRNO) and New York REIT, Inc. (NYSE:NYRT).

Bottom Line

Though uncertain markets and a low interest-rate environment made defensive and high-yielding industries like REITs more attractive in the past, the situation has changed now. REITs are in fact underperforming the broader equity market in recent months amid anticipations of a rate hike and treasury yield issues. While any precise prediction for a rate hike can prove wrong, this does not mean that rates will always remain low. In fact, whenever they do rise, rate-sensitive REITs will bear the brunt if the hike is not accompanied by solid economic growth.

Despite having many positives, there is no shortage of negative factors. Therefore, investors should satisfy themselves by dispassionately absorbing both sides of the argument and then call the shots.

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