How do interest rates affect REITs anyway?

Neha Gupta

Rising interest rates indicate that an economy is expanding robustly as key sectors register topline growth. Real Estate Investment Trusts (REITs) are usually susceptible to interest rates fluctuations given that they operate in the income-oriented sector. While REITs have most of the times been associated with low interest environment, at times they tend to outperform the overall industry on rising interest rates.

Higher interest rates result in an increase in the cost of capital consequently making financing of operations costlier. In some instances, such increases usually result in a decline in business investments and a decline in investors’ confidence.

 

REITs’ appeal in their High Dividend Yield

Investors hold REITs because of their high dividend income. That said, these type of investments tend to do extremely well in low-interest environments where the economy is expanding.

REITs in Singapore are regulated by Monetary Authority of Singapore which dictates how much of the rental income earned should be paid back to investors in the form of dividends. The average yield in Singapore is 5.9%  one of the highest in Asia.

Capital Land Mall Trust is Singapore’s largest real estate investment trust with a yield of over 5%. AIMS AMP CAP REIT is one of best performing yields with a yield of 8%. Ascott REIT, BHG Retail REIT and Ascendas-h Trust all boasts of an average yield of 7%.

A strengthening economy is often depicted by the growth in demand for rental units. Increasing demand in return results in rent and property values hikes, which results in an increase in income distributed to REIT shareholders.

Interest rates hikes always result in an increase in the cost of capital borrowing. Such increases also affect the attractiveness of REITs as an investment when compared to other investments.

 

Interest Rates’ impact on Borrowing Costs


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In a low-interest rate environment, REITs and other business are usually able to borrow capital at much lower interest rates. When interest rates increase, the cost of borrowing also tends to rise, making it extremely expensive for businesses to pursue additional capital needed to pursue growth projects.

REITS usually incur interest only expense on debt financing. Increase in interest rates most of the time results in an increase in interest expense which in the long run reduces cash flow that is available for payouts to shareholders in the form of dividends.

Singapore REITS are saddled by large loans of up to 45% in some cases. These large loans put the REITs at a higher risk should the Monetary Authority of Singapore decide to pull the plug on the current interest rates. Rate hikes in large economies such as the U.S could also have an effect on the country’s REITs market as such hikes could affect borrowing costs abroad.

The more the debt that a REIT has on its books, the more the amount of interest expense it would have to pay in case of an increase in interest rates. A decline in interest rates, on the other hand, tends to result in a fall in the cost of borrowing, which leads to lower interest expense and more cash flow for payments to shareholders.

Health REITs are the most susceptible to rising interest rates because of their significant exposure to long-term leased assets. Most of these REITs are subject to fixed rental rates that are subject to annual bumps. What this means is that as soon as rates increase, their cost of borrowing always increases even as their revenue flows remain fixed pending adjustments.

 

REITs Attractiveness

Higher interest rates affect the attractiveness of REITs when compared to other investments such as risk-free government bonds, stocks, and corporate bonds. Interest rates hikes many at times result in an increase in interest yield in risk-free government bonds which makes them extremely attractive versus other investments.

Higher rates cause yields on newly issued bonds to increase making them more attractive to investors in pursuit of lower-risk generating investments.

In addition to affecting cash flow available for distribution to investors, higher interest rate affects investors’ confidence on REITs stocks. It is common for such stocks to plummet following interest rate hikes. The reverse is also true when interest rates fall.

 

Low-interest environment

Near zero interest rates allows REITs to load up on debt to finance the expansion of property portfolios. Such investments most of the time result in an increase in generated income in the long-run as costs remain low. In return, investors always stand a higher chance of enjoying juicy yields that can exceed 10% depending on the type of REIT.

REITs have long thrived in low-interest rate environment. The Federal Reserve moving to raise interest rates as other central banks around the world consider pulling the plug on low-interest rates continues to evoke concerns in the real estate investment business.

The FED has so far hiked interest rates twice as the U.S economy outperformed its pears. However, concerns about the slowing U.S economy is already raising concern about the impact of a third rate hike on REITs returns.

 

Singapore REITs performance so far

Singapore real estate investment trusts are some of the best performers in the world given the low interest environment. According to data compiled by Bloomberg, the country’s REITs offered the highest dividend yields among developed markets last year.

The high yields propelled FTSE Straits Times Real Estate Investment Trust Index up 8.9% as hungry investors flocked the country to take advantage of the record low interest rates.

A 7% yield offered by Singapore REITS Exceeded 6% offered by REITs in the U.S and Australia. The performance this year has been no different as the Monetary Authority of Singapore continues to remain firm against hiking interest rates.

Investors who bought Singapore REITs five years ago are already enjoying compounded annual return of more than 10%. A good 11 out of 21 REITs tracked by Bloomberg have returned an average of 8 to 12%.

Mapletree Commercial Trust is one of the best performing REITs in Singapore with a return of as much as 18.7%. The worst performer and the only one with negative returns is Sabina REIT which is down 3.5% for the year.

(By Neha Gupta)

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