With little doubt that the
Federal Open Market Committee
will boost short-term interest rates this week, Wall Street analysts have been scrambling to decide what higher rates might mean for groups they cover.
That was especially true in the real estate world, where investors are eager to keep the recent rally in real estate investment trust prices intact. Several reports last week declared that not only were REITs not endangered by a Fed-engineered rise in short-term interest rates, they might actually become the defensive vehicle of choice for rate-shy investors.
Unfortunately, that rosy view wasn't borne out by closer scrutiny of the data. Here's my unvarnished view of several important studies of the performance of REITs during periods of rising interest rates.
Are REITs Right as Rates Rise?
Eric Hemel looked at the relationship between REITs and Treasury rates and compared it to the relationship between the
and bond rates. His conclusion: REITs may provide a defensive investment strategy in times of rising interest rates, relative to the broader market.
Over those 11 years, Hemel found that as rates rise, REIT stock prices decline, though not as much as the general market.
But Hemel's research contains two problems that limit the usefulness of the data, and thus his conclusions. For one thing, changes in interest rates "explained" only 39% of the variability in the S&P 500 over the 11 years and only 26% of changes in REIT prices. Neither of these relationships would be characterized as significant by statistical researchers.
The second problem is that Hemel based his analysis on the past performance of 15-year government bonds, not short-term interest rates. For analyzing the response to this week's likely action, a review of the relationship between the federal funds rate and REIT prices would be more helpful.
Enter John Woo at
Security Capital Group
. Woo researched data based on the monthly federal funds rate changes, as well as the monthly performance of both the
NAREIT Equity Index
and the S&P 500 from 1974 to the present. His conclusion? Changes in short-term interest rates do affect both the performance of REIT share prices as well as the broader market, but rate changes account for less than one-third of the fluctuations. Woo agrees that neither number is terribly significant. "Both correlation figures are low, implying the two variables have very little attribution to each other's movements."
With the empirical evidence mixed, most REIT pundits believe a quarter-percentage-point increase in interest rates would mean very little to REIT investors. "The impact all depends on how far and how fast," says Jim Grissett, portfolio manager of
, an Atlanta-based real estate investment firm. "Twenty-five or 50 basis points on the upside should have very little impact. It would probably take a full percent before REITs really feel the pinch."
But a 25-basis-point move by the Fed with an additional tightening bias is anything but positive for REITs. What the Fed says -- not what it does, this time -- is more important. "I get the sense it depends more on how the Fed positions itself," says Richard Paoli of
Warburg Dillon Read
. "If it looks like there's more to come, that's bad for everyone, including REITs."
REITs May Be Hardier Than Most
Still, there are those who think REITs will weather the interest-rate storm better than other stocks. The reasons, they say, include real estate's natural hedge against inflation, the support of the dividend in a REIT's total return and the attractive valuation of many REITs.
If inflation is the reason for rising rates, many analysts suggest that bodes well for REITs. "REITs will hold up well in inflationary times," says Ken Statz of
. "REITs simply pass inflation through their underlying real estate and the value of those assets will increase." As a result, investors tend to favor real estate in inflationary periods.
Part of the reason rests in the dividend. While rising bond coupons compete with REIT yields, REIT dividends will grow over time while bonds' nominal yields remain fixed. "REITs provide a growth yield where bonds don't," says Paoli. "REIT dividends will grow from one year to the next. If you believe that dividend growth will be about half of the growth of funds from operations
a measure of cash flow, it will almost always outpace inflation."
Finally, some analysts think even with the recent rally in REIT prices, relatively low valuations will provide a solid floor for REITs if the entire market heads south. "REITs are still at the low end of historic valuations. That should provide good support in a negative rate environment," says Paoli.
Winners and Losers
While REITs may hold up well if monetary policy tightens, some will do better than others. I have written about the dangers of both
overleveraging and overzealous
development in past columns, and many think that companies indulging in such practices may suffer more than most.
Those that find success in a rising-rate environment are likely to be those REITs with the healthiest balance sheets. "Performance in a rising-rate environment depends most on a REIT's financial structure," says Grissett. "Companies with significant leverage, large construction and other variable-rate debt will be hurt the most. REITs need to know that and have stable long-term financing in place."
We'll likely know who investors think those companies are come Wednesday.
Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta. At time of publication, neither Edmonds nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback at