Is REIT a good hedge against inflation?

It is commonly asserted that REITs, or Real Estate Investment Trusts, are destined to underperform when interest rates rise. However, an examination of the historical record suggests that this is a misconception.

REITs are companies that own or finance income-producing real estate across a range of property sectors. In the context of US, REITs of all types collectively own more than $3.5 trillion in gross assets, with stock-exchange listed REITs owning approximately $2.5 trillion in assets, representing more than 500,000 properties.  U.S. listed REITs have an equity market capitalisation of more than $1 trillion.

A study by S&P Global reveals that although interest rates certainly affect real estate values and, therefore, the performance of REITs, rising interest rates do not necessarily lead to poor returns.

Between 1992 to 2017, REITs emerged as the winner compared to Stocks, Bonds and Commodities.  Strong long-term total returns, combined with other key investment characteristics such as liquidity, high dividend yields, and their potential to increase diversification and to hedge against inflation, have contributed to the appeal of REITs. 

Nareit also shows that REITs have outperformed leading U.S. benchmarks over extended historical periods.

Since the early 1970s, there have been six periods during which 10-Year U.S. Treasury Bond yields rose significantly. In four of those six periods, U.S. REITs earned positive total returns, and in half of those periods, U.S REITs outperformed the S&P 500. In one of the periods, U.S. REITs and the S&P 500 essentially posted identical performances, and in only two periods did the S&P 500 outperform U.S. REITs (see Exhibit 2).

Undoubtedly, rising interest rates pose challenges for REITs. All else being equal, higher interest rates tend to decrease the value of properties and increase REIT borrowing costs. In addition, higher interest rates make the relatively high dividend yields generated by REITs less attractive when compared with lower-risk, fixed income securities, which reduces their appeal to income-seeking investors.

While it would require a much more detailed study to attempt to determine why REITs have generally fared well in rising interest rate environments, it is clear that rising interest rates are associated with other factors that positively affect REIT fundamentals. For example, rising interest rates are frequently associated with economic growth and rising inflation, both of which are likely to be positive for real estate investments. Healthy economic growth tends to translate into greater demand for real estate and higher occupancy rates, supporting growth in REIT earnings, cash flow, and dividends. In inflationary periods, real estate owners typically have the ability to increase rents, and REIT dividend growth has historically exceeded the rate of inflation as a result. As depicted in Exhibit 3, the income component of REIT returns has exceeded inflation (as measured by the Consumer Price Index [CPI]) in 14 out of the past 15 years.

When expectations about future interest rates change suddenly, REITs (as well as other asset classes) have often experienced high volatility and rapid price changes. This phenomenon was evident in May 2013:

When Fed Chair Ben Bernanke suggested that the QE taper could start earlier than most market participants expected. The chair’s comments led to a sharp selloff of REITs and of some other asset classes, such as emerging market equities, which were viewed as reliant on “easy money” from the Fed. The Dow Jones U.S. Select REIT Index dropped 17.9% from its peak on May 21, 2013 (the day preceding the Fed comments), to its 2013 low on Aug. 19, 2013. However, as markets calmed, the index recovered, subsequently reaching new highs in 2014, and it has continued to rise along with broadbased equity gains in 2017.

Ultimately, whether interest rates are rising or falling does not seem to be the key driver of REIT performance over medium- and long-term periods. Rather, the more important dynamics to address are the underlying factors that drive rates higher. If interest rates are rising due to strength in the underlying economy and inflationary activity, stronger REIT fundamentals may very well outweigh any negative impact caused by rising rates.

Reference

S&P Global, 2021-04-07, “The Impact of Rising Interest Rates on REITs”