Can REITs be a hedge against rising interest rates?


OVER the last 20 years, real estate investment trusts (REITs) have become the global standard for owning publicly traded, investment grade real estate.

Over 35 countries, including every Group of Seven nation, have introduced REIT-like legislation to encourage investment in real estate.

Investors in REITs have been rewarded with strong risk-adjusted returns on both an absolute and relative basis.In Malaysia, M-REITs have performed in tandem with the global REIT market giving their investors solid cash returns over the past 17 years of their existence.

However, we are now witnessing a perfect storm as the world comes out of a series of punishing lockdowns due to the pandemic which resulted in major disruptions to the global supply chain, an unexpected conflict in Ukraine and a major spike in inflation.

The US stock market is off to a brutal start in 2022.

The S&P 500 Index, which is widely considered to be the main benchmark for US stock market performance, declined 13.3% through April, the steepest four-month drop to start any year since 1939.

Stewart LaBrooy: The US-based National Association of Real Estate Investment Trusts has the longest period of performance data on REITs, and that data shows that while REITs have somewhat underperformed the S&P 500 in New York during periods of low inflation, they’ve outperformed that benchmark during times of moderate or high inflation.Stewart LaBrooy: The US-based National Association of Real Estate Investment Trusts has the longest period of performance data on REITs, and that data shows that while REITs have somewhat underperformed the S&P 500 in New York during periods of low inflation, they’ve outperformed that benchmark during times of moderate or high inflation.

The index continues to fall in May and was down 16% year-to-date as of Tuesday’s close, approaching the 20% threshold that some investors consider confirmation of a bear market.

We must be cognisant of the fact that the United States saw a drop due to the Covid lockdowns but soon recovered and started a strong surge.

However, the inflation and rise in key interest rates spoilt the party.

In Malaysia we saw certain sectors perform well despite the pandemic.

Global demand in gloves and palm oil prices sent glove and plantation stocks soaring, banks remained stable, but the property market was badly impacted.

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M-REITs were not spared either and many saw their units’ prices drop by double digits in response to the effects of the extended lockdowns had on their dividend performance and are now trading at historical lows.

The rise in interest rates by 25 basis points last month did not help sentiment either.

Is it time to start taking a defensive strategy and look at REITs as an investment in times of rising interest rates and high inflation? I think so and I will give you four reasons why REITs can withstand a recession and provide investors a safe haven in these volatile times.

For the price of a single share, you can enjoy the dividend pay-outs that by law must equal or exceed 90% of the REIT’s taxable income.

These dividends can often more than make up for any pressure on REIT stock prices, producing market-beating cash returns every quarter. Here is a quick look at the four reasons why.

> REITs own real estate that has real valueIt’s important to remember that a REIT’s own real assets in general have been gaining value over a long period of time.

No one ever loses money on real estate assets in the long run, and it is reasonable to expect that gain in value to continue, as it has through multiple economic cycles.

At the same time, it’s not a straight or even line, and some sectors, of course, are hotter than others at any given moment. Case in point: Industrial assets especially logistics and warehouse facilities are at an unprecedented premium.

For example, our largest industrial REIT, Axis-REIT, have reported that rents and property values are still rising, and they have limited vacancies.

Industrial space is now effectively sold out.

> The stability of leases and rising rents

REIT managers lock in their rental returns through long leases, which assure REIT investors of steady income flow used to pay out dividends.

That’s “steady,” not “static.” Leases typically include rent escalations, which can help blunt the effects of inflation through the several years that a property is committed to the lease.

Of course, leases range widely in duration, and each REIT’s portfolio has a mix of expiration dates, so watch for those escalations to be even higher in the hotter sectors as contracts expire amid rising inflation.

And if M-REIT managers can keep operating expenses stable relative to inflation while raising the rent, that can help sustain or grow their Funds From Operations, a key metric that’s closely watched by investors as a gauge of a REIT’s profitability.

> Interest rates and REIT history

Bank Negara has just raised the overnight policy rate (OPR) rates to 1.75% but if inflation can’t be quelled, we may expect a further rate hike in the fourth quarter of 2022.

We forget however that from 2016-2020 the average OPR rate was 3% to 3.2% and all M-RETs were all performing exceptionally well in that interest rate environment.

The problem is that we have all gotten used to this current low interest rate regime and some businesses over geared their balance sheets as a result. M-REITs however have always kept their gearing low and in many cases locked their borrowings in long bonds with low fixed coupons.

The US-based National Association of Real Estate Investment Trusts has the longest period of performance data on REITs, and that data shows that while REITs have somewhat underperformed the S&P 500 in New York during periods of low inflation, they’ve outperformed that benchmark during times of moderate or high inflation.

> REITs provide liquidity and agility unlike real property assets.

No two real estate sectors are alike, and every publicly traded M-REIT has its own mix of property types, lease terms, geographic diversity, and market conditions.

But they all share the liquidity that allows investors to buy and sell as they see fit in response to inflation and whatever else this pandemic-battered economy presents as a challenge is ultimately a buying opportunity.

M-REITs have been planning for this recovery for the last 24 months but at the same time continued to provide their investors with strong cash dividends every year.

They have spent the last two years cutting costs, optimising their operations, and refurbishing their assets to take advantage when the markets return to normal.

Their unit prices are currently off their highs but when things return to normal their dividend performance will surprise the markets and we will see a strong surge in their share prices.

Datuk Stewart LaBrooy is the secretary of MRMA and chairman of Alpha REIT Managers Sdn Bhd. The views expressed here are the writer’s own.

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