For REITs -- Rising Rates or Rising Rents?

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.

Aside from that example sounding ominous, is it really? Are we really to believe All-REIT's balance sheet is going to absorb all of this added expense? Will the upkeep, safety, and appearance of this facility suffer as a result? Will the top-tier tenants begin to leave, allowing the remaining tenants to negotiate more favorable terms? Will All-REIT have to cut their distributions to shareholders in order to stay afloat? Maybe All-REIT should just shut down the entire operation before things can get any worse....

In reality, the slow but steady rise in real estate prices since 2010 has allowed owners and landlords to refinance debt and reduce their overall costs to service debt. In turn, this frees up cash flow and allows for not just improvements but also expansion -- broadening and diversifying their base of properties, furthering the stability of future distributions.

It's not "good vs. bad," but "better vs. worse"

Concerned about the fact that -- mainly due to still-high unemployment -- historically high commercial vacancies will hurt the owners of retail, office, and industrial space? Consider the fact that the trend is favorable. Unemployment is lower today than it was a year, two years or three years ago. According to the National Association of Realtors, commercial vacancies are all projected to drop (albeit slightly) over the next year.

But maybe more importantly, rents are projected to grow across all segments of commercial real estate over the next two years:

It may also be interesting to note that Macy's (M) stock, a fairly reliable barometer for our retail sector, hit an all-time high on Wednesday, just a day before the 87th annual Macy's Thanksgiving Day Parade. Consider, too, from a valuation standpoint REITs look inexpensive. The Vanguard REIT Index ETF (VNQ) currently trades about 15% below its recent price of 78 (reached in May).

If the trends in vacancy and rent above continue, I believe there could be a great deal of room to run for this asset class. And you'll earn a 3.9% annual dividend in the meantime...

Sometimes arguments are ignored because they are "just too obvious." In this case I believe it's the exact opposite -- the simple argument that rising rates will be bad for REITs is the one being adopted and acted upon. And the selling pressure Vanguard REIT Index ETF has faced as a result may be creating an attractive entry point for the rest of us.

At the time of publication, Scott held shares in VNQ and AMJ.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

 

Adam B. Scott is a founder of Argyle Capital Partners, a fee-only Registered Investment Advisor based in Los Angeles. A veteran of Morgan Stanley and UBS Wealth Management in Beverly Hills, Calif., Adam uses his extensive market knowledge and macro-level analysis to implement customized solutions for high net worth private clients. Adam is an avid tennis player and skier, and volunteers his free time to the Fulfillment Fund, the Tufts Alumni Association and coaching local youth sports.

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