Historically, REITs have done the worst during times of rising interest rates and slowing economic growth.
Well, it appears increasingly likely that that’s what we are facing.
This could have drastic and negative implications for a number of REITs, and therefore, it is more important than ever to be selective.
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RapidEye/E+ via Getty Images Co-produced by Austin Rogers What Could Derail The REIT Train
Real estate investment trusts, or “REITs,” are a phenomenal way for the average investor to participate in the asset class of commercial real estate that has historically been reserved for private investment companies and high net worth individuals. Source: AvalonBay Communities
American REITs ( VNQ ) own approximately $2.5 trillion worth of real estate and have a combined market cap of about $1.6 trillion, implying that the sector as a whole is only capitalized by about 36% debt.
REITs have also enjoyed fantastic returns over long time periods. According to NAREIT, from 1972 through August 31st of 2021, equity REITs (that directly own real estate) outperformed all three major stock indices: the S&P 500 ( SPY ), the tech-heavy Nasdaq Composite ( QQQ ), and the Dow Jones Industrial Average ( DIA ). But as explained in a recent article , REITs perform better in some environments than others. The worst economic environment for REITs is one in which economic growth rates are going down and interest rates are going up . But it appears as though we might be headed for just such an environment, as inflation is speeding up the Federal Reserve’s rate-hiking plans even while projections for future economic growth are dropping.
This would be very bad news for a lot of REITs, if true.
Let’s take a pulse check on today’s economy and try to assess whether and how much REITs are threatened. The Threat Of Inflation & Rising Interest Rates
Since the trough of the COVID-related selloff in March 2020, REITs have surged around 80% to reach a new all-time high as an index. Data by YCharts But are these high prices threatened by inflation and the probability of rising interest rates in the near future?
After all, though the rent rates of hot property sectors like multifamily and industrial are rising even faster than the average rate of inflation as measured by the CPI, many other property sectors and lease types are unable to raise rents fast enough to keep up with inflation.
Many lease terms last five to ten years or longer and have contractually fixed rent rates. Even most of the leases with inflation-based rent escalators are capped at 3-4%.
For these property/lease types, 5%+ inflation slowly eats away at the real value of the REIT’s income stream. Data by YCharts This recent surge in inflation should not be too surprising given that the government has increased the supply of money circulating in the economy by ~35% since the beginning of the pandemic. Data by YCharts This avalanche of dollars entering the economy had the effect of increasing consumers’ capacity to spend even as production halted and supply lines broke down. This is highly unusual for a recessionary period, in which consumption capacity typically falls alongside production, and it is why the official recession (defined by the drop in GDP) only lasted about two months.
But in normal economic times, the productive capacity of the American economy (not to mention the economies of our international trading partners) is so efficient and powerful as to be capable of ramping up output to meet growing demand, thereby preventing big spikes in consumer prices.
The more acute reason why we’ve experienced such a surge in consumer inflation has been the supply chain breakdown. We all know by now about the terrible congestion of container ships at US ports, which spurred the Biden administration to recently order West Coast ports to stay open and operating 24/7. Hopefully, this should ease some of the pressure we see, for example, at the Port of Los Angeles (green dots are container ships): But even once the goods finally make it to shore, the supply chain dysfunction does not stop there. A shortage of truck drivers and other freight transportation services has limited the ability for goods sitting at ports to make it to their destinations.
Freight transportation output, which includes trucking, railways, inland waterways, and air transport, is around the same level or below where it was immediately before the pandemic while personal […]