Interest Rate Dilemma: Should You Sell REITs and Buy Banks?

Royston Yang
·5-min read

It’s been a confusing time for investors who are monitoring interest rates.

Back in September, the US Federal Reserve (“Fed”) has finally cut rates by half a percentage point after holding them at their highest level in 23 years.

This was after the central bank hiked interest rates as their fastest pace ever from March 2022 to July 2023 to combat a surge in inflation.

The good news is that inflation dipped below 3% in July and looks headed towards the Fed’s target of 2%.

But now, another data point has thrown a spanner in the works.

The US labour market remained unusually robust with 254,000 jobs added in September, taking the unemployment rate down to 4.1%.

With this strong incoming data, Fed officials could consider easing the pace of interest rate decreases to ensure that inflation really does come down to their intended target.

As investors, how should you position your portfolio?

The problem with a strong US economy

But wait, isn’t a strong economy good for the US?

Strong job creation implies that the higher interest rate environment has not dented consumer spending and corporate expansion.

Here’s where it gets tricky.

The Fed intended to lower interest rates further by the end of this year and into 2025.

With the economy staying strong and inflation still hovering close to the 3% level, the central bank may decide to slow down or even halt the pace of interest rate cuts.

This is done not without consideration as the Fed wants to ensure that inflation really does come down to the intended 2% level.

How REITs and banks are affected by interest rates

Meanwhile, investors are saddled with the decision as to whether to own REITs or banks.

REITs are negatively impacted by higher interest rates as they are highly geared and rely on debt financing for operating and capital expenditure.

Hence, a higher interest rate will crimp REITs’ distributable income, resulting in lower distribution per unit (DPU).

Case in point: Frasers Logistics & Industrial Trust (SGX: BUOU) reported a healthy year-on-year revenue increase of 8.4% to S$230.6 million for the second half of its fiscal 2024 (2H FY2024).

Finance costs, however, ballooned by 45.6% year on year to S$36.4 million, resulting in DPU for 2H FY2024 falling by 5.7% year on year to S$0.0332.

Banks, on the other hand, thrive in a higher interest rate environment because they get to enjoy an uplift to their net interest income by lending at higher rates.

OCBC Ltd (SGX: O39) saw its first half of 2024 net profit hit a record-high of S$3.9 billion as the bank enjoyed higher net interest income.

The lender also upped its interim dividend by 10% year on year to S$0.44.

Therefore, investors are in quandary as to whether they should sell off REITs to buy banks in case the Fed decides to halt interest rate cuts.

The central bank’s data-dependent approach

This decision is made even tougher with the Fed stating categorically that its approach will be heavily data-dependent.

As new economic data comes in on the labour market, inflation, GDP growth, and job creation, the central bank will calibrate its response accordingly.

Hence, it’s difficult to rely on what Fed officials opine at any given point in time.

The language usually incorporates an element of uncertainty and allows the officials to pivot if need be once they receive new information.

Officials are also unwilling to commit to a fixed path of rate decreases for fear of upsetting the delicate balance between economic growth and inflation.

The best thing that investors can do is to monitor the news closely for signs of whether the Fed will continue to ease, or may tighten and stop the interest rate cuts.

Position your portfolio wisely

So, how should you position your portfolio?

It’s a bad idea to exit either REITs or banks completely because you are exposing yourself to being completely wrong or right.

For instance, if you sell REITs and hold banks, a sustained interest rate cut will leave you out in the cold.

But should you sell banks and hold on to just REITs, a slowdown in interest rate cuts will still cause stress to the REIT sector.

The best choice, in my opinion, is to have a bit of both within your portfolio to mitigate the risks of interest rates heading either way.

You should also stick with the stronger candidates within each category to ensure they can tide through any headwinds.

Some examples may include CapitaLand Integrated Commercial Trust (SGX: C38U), which reported a robust business update for the third quarter of 2024, or Parkway Life REIT (SGX: C2PU), which announced an uninterrupted increase in its core DPU since its IPO in 2007.

As for banks, it’s wise to own any of the three large local banks as they make up the pillar of Singapore’s economy.

Get Smart: Good to have exposure to both

With a cloudy interest rate outlook, it’s useful to have exposure to both banks and REITs.

This allows you to buffer against any outcome and also gives you an opportunity to participate in any growth that may emerge.

Want more dividends in 2024? Our latest FREE report spotlights five Singapore REITs with distribution yields of 5.5% or more, a rare find in today’s market. These are reliable, proven performers. Just one stock inside could boost your portfolio’s returns in the next few months. Download your report today and start reaping the benefits.

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Disclosure: Royston Yang owns shares of Frasers Logistics & Commercial Trust.

The post Interest Rate Dilemma: Should You Sell REITs and Buy Banks? appeared first on The Smart Investor.

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