Real Estate Investment Trusts (REITs) have been a beacon for investors seeking stable dividends and long-term capital appreciation. But when the tides of interest rates rise, the waters can get choppy. Historically, REITs have shown resilience in the face of mounting rates. Over the past 25 years, there have been several instances where REITs not only weathered the storm but also outperformed other asset classes during periods of rising interest rates¹.
A Closer Look at the Data
During six significant periods of interest rate hikes since the 1970s, REITs have often maintained positive total returns. For instance, from December 1976 to September 1981, when the U.S. 10-Year Treasury Yield soared from 6.9% to 15.3%, REITs achieved a cumulative total return of 137.4%, outshining stocks which stood at 46.0%. This trend underscores the potential for REITs to not only survive but thrive during high-interest rate periods.
Impact on Financial Metrics
Funds From Operations (FFO) and Adjusted Funds From Operations (AFFO)
FFO and AFFO are pivotal metrics for assessing a REIT's performance. FFO reflects the cash flow from leasing and acquisition activities, including interest costs, while AFFO adjusts FFO for rent increases and capital expenditures. In times of rising interest rates, these metrics can be pressured as borrowing costs increase, potentially leading to tighter spreads between income and expenses.
Loan Refinancing and Acquisitions
For REITs holding properties like hotels and other commercial ventures, refinancing existing loans or acquiring new properties can become more expensive as interest rates climb. This can lead to more conservative leverage strategies and a heightened focus on operational efficiency to maintain healthy debt coverage ratios.
The Current Landscape: Treasury Rates and Mortgage Borrowing
Today's economic climate sees the U.S. Treasury yields playing a pivotal role in shaping commercial mortgage rates. A rise in Treasury yields typically leads to an uptick in mortgage rates to offset the increased risk. For commercial real estate, this means higher borrowing costs, which can affect the loan-to-value ratios and, ultimately, the valuation of properties.
Analyzing the Trends
With the current Treasury rates, we're witnessing a direct impact on the cost of borrowing for commercial mortgages. This has implications for the cash flow and valuation of REIT-held properties, as higher interest payments may squeeze the net operating income.
Conclusion: Steering Through the Tide
As we navigate the currents of the financial markets, REITs remain a vessel of opportunity. Historical data suggests that while they are not immune to the effects of rising interest rates, they have the potential to adapt and prosper. Investors and stakeholders must keep a keen eye on FFO, AFFO, and borrowing costs to ensure their commercial real estate investments stay afloat in this ever-changing sea of rates.
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