Are REITs a safe place to hide, if interest rates rise?
Some people think so, believing that higher rates would be a sign of a better economy. That would mean more leasing demand for the investments held by real estate investment trusts, such as malls, office buildings, and rental apartment buildings, and hence more profits for owners of these securities.
But the thesis is flawed, according to Michael Smith, an analyst at Macquarie Capital Markets Canada Ltd., who has developed a set of rules for investing in REITs.
Rule No.1, outlined in a recent note to clients, is that "no one will be spared in a rising interest rate environment."
Recent action seems to have borne this out. Last week, as rates rose based on worries the Federal Reserve would become less accommodating in its monetary policy, REITs sold off. They dropped 3.4 per cent in Canada and tumbled 5.2 per cent in the U.S., according to Mr. Smith.
The damage was even more pronounced since May 21, with U.S. REITs sagging 9.4 per cent while their Canadian counterparts are off 4.3 per cent.
Mr. Smith agrees that the better economic environment that would accompany higher rates is a plus for lease demand, although he also believes that higher rental rates take time to be reflected in REIT profitability because it takes time for leases to roll over.
But he warns that high rates "have an obvious downside" of leading to higher interest costs for the financings undertaken at REITs and they also cause investors to demand a higher cap rate, an industry term for the rate of return on real estate, based on the income the property is expected to generate.
Mr. Smith contends the recent price weakness may be overdone and be a good entry point for selected REITs .
"Real estate operating fundamentals in Canada remain constructive and we recommend investors use the current choppy markets to pick up size in some names that historically have been difficult to acquire without significantly moving the trading price. In particular we highlight Boardwalk REIT, Allied Properties REIT and First Capital Realty."
Boardwalk is the company's top Canadian pick, while American Tower holds that ranking in the U.S. Elsewhere in the world, Macquarie's top global picks include GPT Group in Australia, Hyprop Fund in South Africa, Nippon Building Fund in Japan and CDL Hospitality Trusts in Singapore.