What is a REIT?
The real estate investment trust (REIT) industry has existed globally for around 50 years and can be generalized as securities that passively hold an interest in a portfolio of real properties. Therefore, REITs do not conduct business in the traditional sense. Rather than selling goods or services, REITs own income producing properties that are leased out to third party tenants, who in turn operate businesses.
There are several legal requirements for an organization to be classified as a REIT. A firm must hold real estate assets comprising of >75% of total assets, generate >75% of revenue from real estate and maintain a dividend payout ratio of >9%. If these three qualifications are met, the organization is considered a REIT and is exempt from dividend tax on a company level. Due to these tax advantages, REITs are typically able to generate comparably higher yields than other securities. These tax benefits have helped pave the way for major growth within the industry over the past 50 years. In the U.S. alone, there are currently 224 publicly traded equity REITs with a total market capitalization of $1.19 trillion.
In summary, REITs must pay out high dividends to maintain their favorable tax status. With their stable income generation and high dividends, the REIT sector is a favorite in the eyes of many income-oriented investors.
REIT Interest Rate Sensitivity Assessment
When investigating how a low-interest rate environment has affected REITs, it is important to analyze the drivers of two fundamental factors: unit price and cost of capital.
REIT Price Sensitivity:
Asset-Intensive Balance Sheets
In many ways, REITs are inversely correlated to interest rates since their balance sheets are heavily focused on physical assets. To understand how interest rates reduce REIT prices, it is first important to understand how properties are valued. Property value is driven by the net present value (NPV) of all future cash flows from tenants. As interest rates rise, so does the discount rate, reducing the total NPV of property cash flows and the consequent yield that a REIT would attain from an acquisition or development. When yield compression occurs, and property values drop, it results in a lower net asset value (NAV), which is the cumulative value of an entity’s underlying assets. Since a REIT is underpinned by the value of its physical assets, it is common practice for investors to use its NAV to determine reasonable investment parameters. Consequently, as interest rates fluctuate, so will a REIT’s NAV, inherently depicting how a REIT should be valued.
Investors Prioritize Yield
From an investor’s perspective, a low-interest rate environment makes investing in REITs more attractive because it creates a favorable yield spread. A yield spread can otherwise be known as the difference between the average yield attainable from an equity REIT and the market yield on government bonds. Government bonds are used to evaluate the effective return of REITs, as they are both utilized as fixed-income vehicles to generate consistent, steady cash flows for income investing.
Consequently, in a low rate environment, investors will receive a higher yield from REIT dividends in comparison to the government bond market. This is because yield spreads will increase, incentivizing individuals to take on a higher degree of risk and invest in REITs, rather than settling for a low risk, low return investment in bonds. Simply put, the higher the yield spread, the more attractive the risk adjusted return will be for investors when compared to government bonds, which are considered risk free.
On the opposite end of the spectrum, as interest rates rise, REIT yields become less attractive compared to alternative investments. On a direct property level, the yield achieved by a property owner can be characterized by its going capitalization rate; therefore, it is common practice to compare national average cap rates against bond yields, as an alternative to dividend yields. A cap rate is defined as a property’s net operating income over its total value, so in Canada’s sustained low-rate environment, cap rates have been compressed by rising property values, generating increasing yields spreads.
Alternatively, an individual can evaluate a REIT’s adjusted funds from operations (AFFO) yield, directly characterizing how effective a REIT’s AFFO yield is in comparison to bonds. Recently, a 25 basis points (bps) hike in interest rates has led to a narrowing yield spread, attracting the attention of many investors who are already cautious over the inflated Canadian real estate market.
Cost of Capital Dependent:
Strategic Capital Structure Management
A REIT predominantly operates with a significant amount of leverage, ranging from 40% to 60% of its gross book value. In a standard company, this would be a major cause for concern, as a high degree of leverage translates into high-interest payments and more risk. However, a REIT’s revenue stream is not volatile, enabling stable cash flows and allowing it to operate with higher levels of debt effectively. Over the past few years, the low rate environment has allowed REITs to increase leverage, with only a marginal increase in risk. Similarly, it has allowed REITs to refinance or pay off high-interest mortgages, in favor of debt with longer repayment periods and lower rates. To repay high-interest debt and to facilitate growth, a REIT may also raise capital through equity issuances. When operating with a highly levered investment platform, it is crucial for a REIT to be able to manage its capital structure efficiently. In Q1 2017, the Canadian REIT universe raised $1.5B of equity-related capital, compared to a scanty $23.0MM in quarter one 2016. The significant injection of liquidity into the real estate market has allowed REITs to expand and grow quickly, through both organic and accretive means.
A Catalyst of REIT Growth
Interest rates directly influence a REIT’s growth capacity, by determining the cost and supply of capital. Due to the fact that a REIT pays out at least 90% of its net income to unitholders, it does not hold additional capital to reinvest into properties, forcing it to rely on debt or equity issuances to grow. Therefore, affordable cost and volume of capital available within the market is a major determinant of a REIT’s growth potential. A low rate environment stimulates the real estate industry since institutions are willing to supply more capital at affordable rates. Consequently, REITs are able to expand quickly and secure more lucrative returns on investments. Increased acquisition activity and rising rental rates have allowed the Canadian Capped REIT Index to outpace many global peers, boasting a 3.7% total return in quarter one 2017 and a 3.0% increase in the total market cap. The short-term outlook for the Canadian REIT’s cost of capital remains favorable, indicated by all-time low-interest rates and favorable 5-year commercial mortgage rate trends. In the long term, the cost of debt is anticipated to rise, as the rising interest rate environment will pressure mortgage rates to increase.
A Deep Dive into Mortgage Rates
A change in interest rates has a multidimensional effect on an economy; however, when it comes to real estate, the most heavily analyzed factor is the impact on mortgage rates. Mortgage rate fluctuation can be directly attributable to a change in bond yields, or more specifically, the difference between bond yields and mortgage rates, known as a loan spread. In Canada, it is common practice to track the spread between the 5-year commercial mortgage rate (CMR) and the 5-year GOC bond yield. GOC Bonds are guaranteed to be repaid, whereas commercial mortgages are not, demanding a higher interest rate to compensate for a higher risk. In a declining interest rate environment, GOC bond yields will decrease, allowing lenders to provide mortgages at a lower rate. In essence, the spread between GOC Bonds and CMRs represents the required rate of return for investors. Historically, loan spreads fluctuate between 160 and 200 basis points (bps), with a long-term average of 180 bps. Throughout 2016, the five-year CMR remained at all-time lows, fluctuating between 2.5% and 2.9%. Over the same period, the 5-year GOC yields oscillated between 0.6% and 1.1%, leading to a Q1 2017 spread of 169 bps. All time low loan spreads have been sustained by a prolonged low rate environment and as the GOC 5-year bond yields continue to slip the CMR may follow. Even though the short-term outlook for real estate debt remains favorable, driven by low-interest rates and low GOC bond yields, many experts predict that CMR rates may rise by the start of 2019.