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For REITs -- Rising Rates or Rising Rents?

Stocks in this article: VNQM

NEW YORK (TheStreet) -- Which is more important? We've been hearing about how rising rates will have a negative impact on dividend-paying assets and sectors like Real Estate Investment Trusts (REITs) and Master Limited Partnerships (MLPs). The argument is that as rates rise to more normalized levels, companies in these categories will be forced to pay more for their revolving debts. And these are companies that typically carry high levels of debt. That sounds bad!

Additionally, if interest rates move higher, then yields on investments like Treasuries, agency bonds, and high grade corporate debt will follow -- the cash flow REITs and MLPs pass through to shareholders surely won't look as attractive in comparison. That sounds really bad!

Right?

Not necessarily. The argument above fails to peel back more than one layer of the onion that is the free market. Owners, landlords, and CEOs have the ability to raise prices to keep up with not just inflation, but with the market. A stock, home, lease or product is only worth what someone is willing to pay for it. But this works both ways -- if a client or tenant is willing (forced) to pay a higher price, then that same higher price is set for the clients and tenants behind him.

As both residential and commercial real estate prices have rebounded, so too have the rents that can be commanded by owners. And it's true that as the rates real estate owners pay on their variable debt moves higher, those additional costs will be passed on -- but that will primarily be to the tenants, not the shareholders. We just renewed our office lease and rent is now more than 20% higher than it was the past two years.

Let's look at the hypothetical scenario in which a large shopping mall in Suburbia, U.S.A., is valued at $200 million and is owned by All-REIT, LLC. All-REIT owes $150 million on the property and the average cost of their funds is 4%, meaning the annual interest alone to service debt is $6 million. Let's further assume All-REIT has only been able to fix the rate on half of that $150 million, leaving $75 million exposed to interest rate risk. Should rates rise meaningfully from here, and All-REIT's cost of funds goes to 8% on that $75 million, their annual interest expense will have skyrocketed to $9 million - a 50% increase.

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