Tuesday, 21 March 2017

HOW INTEREST RATES AFFECT REITS



The Federal Reserve has decided to raise interest rates for the third time since the 2009 financial crisis. While higher interest rates would usually depress prices of stocks with high dividend yields, such as REITs and utilities, their share prices held steady or went up after the decision for the interest rate hike was announced last week. The last two rate hikes negatively affected the markets, but this time, investors were relieved that the Federal Reserve did not indicate a more hawkish outlook.

However, rising interest rates will still affect REITs, due to their business model. REITs are often heavily reliant on debt to fund their properties, and rising rates would increase the cost of borrowing. In addition, investors usually include REITs in their portfolios as a proxy to bonds, and bonds tend to perform poorly in periods of rising interest rates.


Increased cost of borrowing


REITs are primarily funded by debt to purchase investment properties, usually through issuing bonds or notes. Higher rates increases the cost of borrowing, which means that REITs have to pay a higher interest on their borrowings, which reduces their distributable income. Based on their latest quarterly financial reports, the average cost of debt for Ascendas REIT and CapitaMall Trust, is 3.0% and 3.2% respectively. Average cost of debt is the ratio of interest expense over average weighted borrowings. 

When interest expense increases, another indicator to watch would be the interest coverage ratio, calculated by dividing the earnings before interest and taxes over interest expense. A higher ratio is preferred, as it reflects the company's ability to service its debt. 

REITs can mitigate the impact of rising interest rates by borrowing during the past few years to lock in low interest rates. If the REIT has a long average term to maturity for its borrowings, and at low fixed interest rates, a rise in interest rates would not affect the REIT much in the near term. However, in the medium term, when the debt matures, REITs would have to borrow at higher interest rates, increasing their interest expenses.  


Rise in risk-free rates


Risk free rates rise when interest rates are raised. In Singapore, the interest rate on the 10-year Singapore Saving Bonds is currently 2.27% annually. Investors typically invest in REITs as they seek a higher yield, but owning securities is riskier than holding government bonds. Investors therefore would demand a higher risk premium from REITs over the risk free rate. 

Assuming that the yield spreads between the 10-year Singapore Saving Bonds and REITs remain relatively stable, a higher interest rate means that investors would demand a higher yield from the REITs. If distributable income does not increase, the prices of REITs would have to fall to give a higher yield. 


Conclusion


During a period of rising interest rates, REITs tend to perform poorly, and we are bearish on the sector. With the Federal Reserve indicating that it intends to raise interest rates another two times this year, we foresee further weakness ahead for REITs. Nonetheless, we continue to look for REITs paying stable dividends, with low debt to equity ratios and high portfolio occupancy rates. When the opportunity arises and prices of REITs have declined sufficiently, we will make our investments. 



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