While low interest rates are typically thought to be an advantage for buying real estate, more than one factor plays a role in the success of any investment, including REITs, or Real Estate Investment Trusts.
REITs that manage assets (known as equity REITs) buy real estate, lease the space to tenants (often through a master tenant) and collect rent. The rent is income that is distributed to the shareholders. In order to maintain its tax-advantaged status as a REIT, the company must distribute at least 90% of its taxable income to shareholders annually. Mortgage-focused REITs buy mortgages or mortgage-backed securities, and as a result, their income stems from the interest payments. Those companies may have a different view of the interest rate environment.
Whether a REIT is focused on property or financial assets, at least 75% of the company’s gross income must come from real estate (rent or sales) or real estate finance (like mortgage products). While rising interest rates may affect real estate prices, there is no clear association between increasing interest rates and poor returns from REIT products.1 Low rates may indeed increase the attractiveness of REITs, which may be better able to find bargains in financing purchases, construction, and refinancing. REIT dividends may potentially be attractive to investors seeking returns in a low interest rate environment as well.
If the investor is considering private REITs, the fees the REIT charges can make a more significant impact on the return to the investor than the effect of interest rates. If the REIT has a high fee structure, that may reduce the dividends available to the shareholders more than rising interest rates.
Looking at REIT performance and interest rates historically, there have been six sustained periods since the early 1970s during which the 10-year Treasury yield increased notably (signifying inflation).2 The data on REIT performance from the previously cited S&P research indicate that the investment vehicle type had a positive average return in four of the six indicated periods and performed better than the market overall in three of the six.
While rising interest rates can raise the cost of borrowing and may reduce the value of property that is in a REIT or sought for inclusion in one, higher interest rates are typically associated with economic growth and higher inflation, which can be a positive influence on real estate investments. In addition, when inflation is rising, landlords may be able to raise rents, and research shows that REIT dividends historically outperform inflation.
1 The Impact of Rising Interest Rates on REITs, S&P Dow Jones Indices LLC, July 2017
2 Federal Reserve Bank of St. Louis