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Quarter-End Insights

Real Estate: Rising Interest Rates Wreak Havoc on REITs

We prefer REITs with reasonable leverage, moaty assets, demonstrated historical success across economic cycles, identifiable growth drivers, and reasonable margins of safety.

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  • As investors' concerns about potentially higher interest rates increase, they should focus on moaty REITs with reasonable balance sheets, good growth prospects, and relatively attractive valuations. Overall, our U.S. real estate coverage appears roughly fairly valued. After a recent pullback, value is emerging in the Australian property sector. Asia-Pacific property still offers attractive yields relative to conventional income products such as bonds.
  • Rising interest rates may be an immediate valuation risk to REIT share prices, but long-dated in-place debt maturity schedules mute the near-term impact on REIT cash flows.
  • Capital is increasingly flowing across borders for property investments, and property values are high.
  • With acquisition prices high, more REITs are expanding their development pipelines, with initial yields projected to be 200 basis points or more above acquisition cap rates.

We expect REIT prices to generally move inversely with changes in long-term government bond yields. Although higher interest rates would take some time to show up in REIT financial metrics, eventually higher rates could cause higher debt financing costs, put pressure on traditional after-interest expense measures of REIT cash flow (such as funds from operations, adjusted funds from operations, and funds available for distribution), and lead to higher cap rates, which could pressure investment spreads. Also, to the extent that low interest rates have diverted investor funds to REITs searching for higher yield, funds could flow out of REITs if interest rates rise, pressuring commercial real estate and REIT valuations.

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Todd Lukasik does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.