Commercial real estate (CRE) is a widely followed asset class that is fluid and receptive to changing global and domestic capital flows. CRE industry became more institutionalised and structured with the advent of REITs in developed economies while witnessing acceptance in high growth economies with large CRE stock. The stability and practicability of revenues, value creation and tradability, of assets under a REIT is comparable with sovereign or corporate bonds, therefore are deemed less risky.
However, REITs are prone to risks such as corporate structure, management quality, REIT manager’s ability to improve asset values, supply of new rental stock, stability of micro-markets in the demand cycle. On the macro level, additional risks include general and local economic conditions, interest rate fluctuation, credit risks, and liquidity risks amongst others.
Interest Rate Fluctuations – Correlation with other investment avenues
Stocks are sensitive to interest rate, provided the price of the stock is influenced by any fluctuation in the interest rate movement. If shareholders perceive rising interest rates to negatively affect a company’s profits, then the stock’s price will drop when interest rates rise and vice versa.
Stocks with high yields are interest rate sensitive because, in a rising interest rate environment (usually in a scenario of economic growth), shareholders of such stocks will prefer safer T- bills or money market instruments provided their yields become competitive with other higher yielding stocks. A typical REIT investor will target attractive total returns with modest risk profile while investing through a REIT platform. When interest rates rise, some investors which get stable returns from fixed income debt instruments (bonds, debentures etc.) will also start evaluating alternatives such as REIT.
However, it’s interesting to note that, historically, REIT prices have not correlated very well with bond prices. Exceptions to this being Unites States, where there is modest correlation between a REIT stock and a high-yield corporate bond index between year 2000 and 2020. This could be attributed to the fact that the strengthening of U.S economy is associated with spike in interest rates. Strengthening of economy leads to improvement in commercial space take up thereby benefitting the REITs as property owners.
A related drawback of this phenomenon is whether interest rate spike would impact the growth of Funds from Operations (FFO), with a resultant drop in asset values. Commercial real estate prices are mainly influenced by borrowing costs and required return on investment. A substantial increase in interest rates will usually impact these variables and thus put downward pressure on property values. This is a complex issue, and dependent on specific REIT, it’s target sector and depth of the micro market where the properties are located.
Following paragraphs, broadly analyse the impact of interest rates on various aspects of the REIT mechanism.
Impact of rising interest rate on REITs debt exposure:
REITs normally use leverage to enhance return on their investment and will frequently borrow to fund acquisition and undertake development. REITs can borrow at variable rate and the lender adjusts the rate according to the interest rate environment. When interest rates rise, a substantial amount of such debt which is carried by a REIT can impact its profit margins and FFO. However, it is to be noted that many REITs carry fixed rate debt on their books and thus the likely impact of interest rate increase will be far lower than anticipated unless funding of new assets through debt at higher interest rates pushes up the average leverage based outflows for the REIT.
Impact of rising interest rate on sentiments of potential tenants:
Businesses are very responsive to interest rate changes which could signal the change in the projected growth rates and earnings. However, it is not necessary that any increase in interest rates have negative impact as strengthening of interest rates also indicate improvement in demand cycle which could result in higher CRE absorption. REITs benefit in this upward movement due to the increased demand. However, as interest rates further increase, this positivity turns south adversely affecting demand. This may lead to fall in value creation either leading to space consolidation or curtailing the requirement for new space. REITs bank on long-term leases at fixed increments that provide steady yields, to cushion the squeezing of fresh demand in a slowing economy. However, if the slowdown prolongs, property owners are likely to suffer due to decline in occupancy and downward rent revisions as businesses renegotiate to navigate the tough economic climate.
Impact of rising interest rate on REITs stock price:
When a REIT chooses to raise capital through equity offerings rather than debt financing, higher interest rates can have an adverse effect on REITs share prices. REITs nominal cost of equity capital, and perhaps its long- term financing cost will increase as well. Usually, property buyers will insist on higher real estate returns when interest rates have moved up, this will affect the asset values of the properties owned by REIT. Asset values are important determinants of REIT’s intrinsic value. Therefore, weakening of asset values may impact REITs share pricing.
However, raising interest rates also signal improvement in marco-economic fundamentals which can be seen as beneficial, driving up the earnings of REITs. In the interest rate cycle, the initial upward momentum of the interest rate can cause better value realisation from increased earnings of rentals and strong leasing market providing an instance of inverse relationship before the relationship becomes more direct higher up the interest rate curve and the impact of high inflation is felt on the value of REIT assets. Further, the improved economic environment provides opportunities for REITs to fortify their balance sheet and reduce debt thereby taking off the impact of interest outflows which can work positively for the pricing of the REIT.
Impact of rising interest rate on REITs equity:
Rising interest rates will tend to increase real estate cap rates, thereby providing an opportunistic environment for REITs to further grow the assets under management. The increase in base assets means more earnings per unit of REIT thus having positive impact. However, as the rate continue to rise, the limitation to increase yields will result in the investors to seek more attractive investments create trade arbitrage. Specific REITs that are sensitive to interest rates specifically like apartment or student housing REITs where increase in interest rate will push REIT value down.
Impact of rising interest rate on REITs competition:
This relates to the overbuilding threat. The construction of new, competing projects, whether office buildings, industrial buildings, warehouses, hotels, or any other type of property, must be financed through debt. Higher interest rates will increase borrowing costs thereby the project cost shall increase for most developers, asset owners. As the threat of overbuilding persist in a steadily rising interest rate scenario, this can act in favour of a well-managed and well-funded REIT.
Conclusion
Potential GDP growth in India is now expected to average 5.5% a year in 2019-28, slower than the estimated 6.9% p.a growth between 2009-18. Inflation is expected to remain sticky around 6% in the short term. Interest rates are also forecasted to remain subdued over the short to medium term. In such scenario, it remains to be seen how the economic sentiments pan out over the short to medium term driven by various policy measures, spending pattern amongst the consumer class as well as demographic growth. REITs are a cashflow product and their prices are sensitive to interest rates in the economy. In such scenario, the performance of REITs, will largely depend upon how each individual REIT is managed in terms of their acquisition strategy including their engagement with the development partner and relationship with the tenants, financial prudence, risk management strategy amongst others.
