May 2013 marked a key moment in time for REIT investors. The U.S. Federal Reserve started to talk about tapering its bond purchases, and the focus for many interest-sensitive sectors went from fundamentals to how fast and high rates would go. The REIT sector was no different.
The S&P TSX Capped REIT Index dropped 18.2% from April to August 2013. This was the largest drop the sector had seen since the crisis, and coincided with the 10-year U.S. bond yield rising from 1.68% to 2.97%. A prevalent view at the time was that if rates were going higher because U.S. economic growth was forecasted to return, investors would likely want to increase exposure to more economically sensitive businesses, while avoiding the stable, contractual-type income that REITs provide.
In short, investors became more focused on macro predictions than on how underlying businesses were performing. But investors also should have been asking, “What would free cash flow (a key measure for REIT performance) look like if we were heading into an environment of rising interest rates accompanied by economic growth?”
In an improving economic environment, a commercial property landlord could expect steady growth in occupancy and rent. This would help raise revenue as more space gets taken up, or as leases expire. (Usually about 10% to 20% of leases expire every year, depending on property type.) What about interest expense? One of the largest expenses a REIT faces is its interest cost on debt. Most REITs in Canada have about 40% to 50% of their capital structure in debt, but ladder their debt maturities. This means only 10% to 15% of that debt will mature in a particular year, causing two reactions:
- the REIT is not bound to interest-rate movements at any point in time, since only a portion of its debt is exposed to new rates; and
- the REIT’s overall cash flow benefits from the rise in revenues over time, which helps offset a rise in its interest expense due to a rise in rates.
These characteristics mean the REIT can withstand most economic and interest-rate cycles.
A closer look
REITs can generate free cash flow growth from five main areas:
- occupancy increases;
- contractual rental increases;
- renewal rental increases;
- development activities; and
- interest-rate savings on refinancing.
Canadian and U.S. REITs saw free cash flow growth of 5.8% and 10.4%, respectively, in 2013, driven by these five factors. This growth is above historical averages, which are closer to 4% in Canada and 5% in the U.S. And, even with the continued focus on higher interest rates, Canadian and U.S. REITs are continuing to see interest-rate savings on debt refinancing, as expiring debt continues to remain above the all-in cost of new financing.
The other key valuation metric for REITs is net asset value (NAV), the value of the underlying properties that a REIT owns. In a scenario of rising rates, investors would immediately be concerned about rising capitalization rates (i.e., the rate utilized to discount the net operating income of a REIT). A rise in cap rates alone would lead to a drop in asset values and, in turn, NAVs for REITs. But it’s unfair to look at this metric in isolation.
Cap rates may head higher as the cost of debt (capital) increases. But an improving economic environment increases net operating income from higher rents and occupancies. This helps to offset a rise in cap rates, which are also a function of the supply and demand in the transaction market. Also, as cap rates head higher, more institutional investors with longer-term time horizons will seek steady yields, especially if this is in conjunction with higher capital availability. This helps NAVs maintain stability in the face of higher rates.
Looking even closer at the risk/reward scenario for REIT investors as of January 6, 2015, the implied capitalization rate spread of Canadian REITs versus the Canadian 10-year bond yield stands at 453 bps. Historically, since Q1 of 1998, this has been closer to 363 bps: an indication that REIT investors are still pricing in a buffer, likely because of the continued fear of higher rates. There are two main risks to the REIT sector:
- Recessionary risk. A deep economic recession would mean that tenants will likely leave occupied space or be unable to pay higher rents.
- Credit risk. A credit contraction may prevent REITs from refinancing expiring debt, or they may be forced to do so at extremely high interest rates.
What happened to the REIT sector in 2013 reflected none of the large risks outlined above, since there was no recession or credit crisis. Investors experienced heightened levels of volatility as fundamentals were ignored. Meanwhile, in 2014, analyst consensus had interest rates heading higher, but the 10-year bond yield in the U.S. fell dramatically instead. At the same time, Canadian and U.S. REITs were poised to deliver above-average free cash flow. A combination of these factors led to the FTSE EPRA/NAREIT Developed Index delivering a return of 15.9% last year, which outpaced broad market indices in most developed countries.
While interest rates are certainly part of the equation, they don’t tell the whole story. Volatility will never disappear. But having a steady portfolio allocation to the REIT sector and focusing on cash flow is the best way to avoid getting caught trying to predict macro trends. With more than 70% of a REIT’s total return coming from the compounding of monthly income over time, it’s important to stay invested to allow real estate to do what it’s designed to do—provide stable income with modest capital appreciation over time. Trying to trade in and out of the REIT sector based on interest-rate movements is detrimental to returns.
by Michael Missaghie, senior portfolio manager at Sentry Investments.