• Thu. Dec 1st, 2022

How do rising interest rates affect REITs?

ByWillie M. Evans

Apr 26, 2022

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

Real estate stocks tend to fall when inflation rises because they are negatively correlated to movements in interest rates.

Market history tells us that when interest rates rise, due to unexpected increases in inflation, real estate stocks tend to lose value more than 60% of the time.

If real estate stocks are inversely proportional to interest rate risks, can we also assume that the same is true for SCPIs or REITs?

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

One is to increase borrowing costs. Higher interest rates can make the costs of acquiring new assets higher if REITs finance their expansion with debt.

If REITs are highly leveraged, higher borrowing costs may also reduce their distributable income, which may result in lower dividend payouts and returns.

The other way is to increase the cap rate or capitalization rate that many real estate appraisers use to value properties. Rising interest rates may increase the cost of capital for REITs, which may result in higher capitalization rates.

A high capitalization rate may cause the net asset value or net asset value of REITs to decline, which could cause REIT share prices to fall.

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

Assuming that FILRT generates a net operating profit (NOI) of 1.6 billion pesos per year, we can divide its NOI by its cap rate of 3.24% to obtain a valuation of its investment properties at 49 .2 billion pesos.

Now, if interest rates continue to rise and the 10-year bond yield rises to 7.11%, the FILRT cap rate will also rise from 3.24% to 4.2%.

Applying a higher capitalization rate to the same net operating income of 1.6 billion pesos will result in a 22% decline in the valuation of FILRT’s investment properties, resulting in a value lower net asset.

While rising interest rates can indeed pose serious challenges to REITs, an examination of the historical performance of REITs on the Philippine Stock Exchange would show that they do not necessarily lead to negative returns.

If we combine the market capitalization of all REITs listed on the market and correlate its changes with the movement towards 10-year bond yields since 2020, we will find that, unlike regular real estate stocks, REITs are positively correlated with rates. interest in 79% of cases. time.

This high correlation means that over the long term, REITs tend to move in the same direction as interest rates, as REITs adjust their rental rates upward with inflation over time.

If we look at the current REITs in the market today, we will find that almost all of them have contract rent escalation rates of 5-10% per year.

Annual indexing rates allow REITs to increase their income over time, which translates into higher dividend growth and stock price appreciation.

Rising interest rates this year, which saw the yield on 10-year bonds rise from 4.7% in January this year to 6.1%, led to a correction in REIT prices, leading to higher average dividend yields of 5.2% to 5.6%.

Rising interest rates may make REIT dividend yields less attractive in the short term due to the higher yields offered by less risky fixed income securities.

If average dividend yields were to catch up with the current 10-year bond yield at 6.1%, REIT stock prices could fall a further 6.4% on average in the coming weeks.

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

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

Henry Ong is a Registered Financial Planner of RFP Philippines. Stock market data and tools provided by First Metro Securities. To learn more about investment planning, attend RFP Program Batch 95 in May 2022. To register, email [email protected] or text at 0917-6248110

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