Many dividend investors wonder how higher interest rates will impact REITs, and for good reason.

Over the past few years, interest rates have fallen to their lowest levels in recorded history.

This has created a challenging environment for income investors who previously enjoyed healthy, low-risk returns from money market funds, CDs, and Treasury bonds.

In fact, since the darkest days of the financial crisis, many yield-starved investors have been forced to search elsewhere for their income needs, including bond alternatives such as real estate investment trusts (REITs).

[ad#Google Adsense 336×280-IA]As a result, the entire real estate industry outperformed the market even during one of the longest and strongest bull markets in history.

Since March 2009, the Vanguard REIT Index (VNQ) returned roughly 400%, outpacing the S&P 500’s total return of about 300%.

However, now that interest rates are finally on the rise (the chart above shows the 10-year Treasury yield over the last year), many dividend investors are understandably concerned about whether or not REITs are still a good sector to own.

Let’s take a look at the long-term history of how REITs respond to varying interest rate environments to see which ones, if any, are most likely to continue doing well in the coming years.

More importantly, find out what REIT investors need to know to better manage the risk in their portfolios as interest rates potentially rise.

Are Higher Interest Rates Bad for REITs?
Interest rates have never been this low for this long in human history, making many of the academic studies about rising rates potentially less relevant.

The good news is that we have some real-time data to analyze on the impact of higher rates on REITs because yields are up sharply since last summer.

In fact, the 10-year Treasury yield has increased more than 120 basis points since the start of July 2016, nearly doubling to reach about 2.6% today.

While that might sound like a significantly higher yield, you can see that it actually remains very low compared to the 10-year Treasury yields recorded over the last 60 years:

Source: Federal Reserve Bank of St. Louis

The S&P 500 Index has returned over 14% since rates started rising last summer, but many high-yielding, low volatility dividend stocks have not been so fortunate.

The table below shows the total return from 6/30/16 through 3/15/17 for a number of popular high dividend ETFs and sectors.

You can see that each of these groups of dividend stocks trailed the market, and three actually lost money over this period, recording a negative total return.

REITs were the worst performing group, losing 6.5% to trail the S&P 500 by a whopping 20.9%!

Source: Simply Safe Dividends

There are two reasons why interest rates matter to REITs, and both have to do with the underlying business model of this high-yield industry.

REITs exist so that the companies that own the properties can avoid paying corporate taxes as long as they distribute 90% of taxable income as unqualified dividends.

This means that REITs aren’t able to retain their earnings or adjusted funds from operations (AFFO – the REIT equivalent of free cash flow).

Thus, in order to grow, REITs need to raise external debt and equity capital from investors. As a result, higher interest rates increase a REIT’s cost of debt and make it incrementally harder to achieve profitable growth.

That’s especially true because REITs frequently use secondary offerings (i.e. they sell new shares) to raise growth capital.

Realty Income (O) has more than tripled its share count since 2005, for example:

Source: Simply Safe Dividends

Management has to make sure that any new properties it buys are still accretive to investors, meaning that the additional AFFO growth is enough to offset the dilution it took by issuing new shares to fund the property acquisitions.

In other words, AFFO per share needs to continue growing in order for the dividends to grow in a sustainable and secure manner.

However, when interest rates rise, bonds, including risk-free Treasury bonds, decline in value, causing their yield to rise.

REITs compete for new capital with bonds, as well as savings accounts, money market funds, and CDs.

Some investors who own REITs today might be inclined to sell their shares if rates rise because they can now achieve similar but less risky yields elsewhere.

To put it another way, because REITs are often seen as bond alternatives, higher interest rates could mean decreased demand for REIT shares, causing a REIT’s yield to rise.

While that’s great for dividend investors looking for new places to put money to work, it can also be a problem for the REIT’s long-term growth prospects.

That’s because the higher a REIT’s valuation (i.e. share price), the less new shares it takes to raise growth capital.

In other words, the less dilution to existing investors is needed in order to continue growing a REIT’s AFFO, and thus its dividend.

Think of it this way. Suppose a REIT currently yields 5%, and management is able to buy new properties at a capitalization rate (annual net income / purchase price) of 7%.

Even if the REIT has to raise 100% of the capital to buy a property by selling new shares, then AFFO per share will still increase, and so will the dividend.

And if the REIT buys the property with a 50/50 mix of equity and debt (with an interest rate of 4%), then the amount that AFFO per share increases is even more due to less dilution and an even lower weighted average cost of capital, or WACC.

However, if interest rates increased to 6% and a REIT’s shares fell enough to raise the yield to 8%, then suddenly the ability to buy that property with 100% equity capital disappears.

The 8% yield a REIT would have to pay on its newly issued shares is more than the 7% capitalization rate it earns on its property, destroying shareholder value.

In other words, the REIT’s cost of capital has risen high enough to not make the deal accretive.

REITs essentially have an optimal growth sweet spot, in terms of their yield. If shares are too expensive, then the yield is too low for investors to earn the income they need.

But if shares are too cheap for too long (due to higher interest rates), then the REIT gets cut off from growth capital and can’t expand its property portfolio and dividend.

So with the Federal Reserve predicting that interest rates will rise by about 2.5% in the next few years, are REITs a bad investment idea?

Not necessarily. What it does mean, however, is that you need to stay diversified and be highly selective with which REITs you add to your portfolio.

The Best REITs Can Still Grow Despite Higher Interest Rates
It’s important to note that REIT share prices aren’t just affected by interest rates but can and do trade on other factors, including a REIT’s fundamentals, long-term growth prospects, and dividend growth history.

As you can see, REITs have been positively and negatively correlated with interest rates during different periods of time since 2005, indicating that there are other factors influencing their returns.

Source: Hoya Capital

Like all other stocks, shares will periodically trade at large premiums and discounts to a REIT’s intrinsic or fair value.

A quality management team will take advantage of these periods of overvaluation to raise more equity capital when the cost of equity is low (high share price), and then raise cheap debt capital when shares are undervalued (low share price).

This kind of smart capital management is why blue chip REITs, such as Realty Income, have a history of consistent growth throughout all kinds of interest rate and economic environments.

In fact, during the last period of rising interest rates, Realty Income was able to grow its cash flow per share by 8.1% per year compared to the median REIT’s 4.4% annual growth.

Source: Realty Income Investor Presentation

While higher interest rates make it harder to grow profitably (due to higher costs of capital), higher rates also tend to depress real estate prices. Therefore, a quality management team can acquire new properties for lower prices and thus higher cap rates.

Realty Income is among the most beloved dividend growth stocks in the REIT sector because of its world class management team’s consistent adaptability and consistent track record of steadily rising payouts. Its monthly dividend payout schedule doesn’t hurt the stock’s appeal either.

Essentially, a quality REIT (the only kind worth owning) is one that, like any dividend stock worth owning, can consistently grow no matter what the economy or interest rates are doing.

Not All REITs Are Equally Rate Sensitive
Of course, just because higher interest rates won’t stop the best REITs from delivering sustainable and consistent dividend growth doesn’t mean that all REITs are equally sensitive to interest rates.

For example, mortgage REITs, which invest in residential or commercial mortgage securities instead of physical, rent accruing properties, are extremely rate sensitive and thus far riskier than most equity REITs (those that own rental properties).

This is because the share price of mortgage REITs generally trades as a multiple of its net asset value (i.e. book value per share).

Since the value of a mortgage bond trades inversely to interest rates (higher rates cause mortgage bond values to decline), higher rates will mean that the NAV of a mortgage REIT will decline and often take the share price with it.

Of course, as with most things in finance, mortgage REIT investing isn’t as simple as saying, “Don’t own mortgage REITs if rates are rising.”

After all, mortgage REITs make their money by borrowing at short-term (i.e. low) rates and then investing in longer-term (i.e. higher-yielding) investments.

If short-term rates rise slowly over time but longer-term rates rise quicker (i.e. the yield curve steepens), then a mortgage REIT’s profitability will actually grow, cash flows will strengthen, and the dividend becomes more secure.

This will attract more investor capital, meaning a rising share price, which will further allow management to keep raising cheap enough equity capital to keep growing.

The best kinds of mortgage REITs to own in a rising rate environment are those that will actually benefit from rising rates.

Mortgage REITs that borrow at fixed rates but lend at mostly floating interest rates include commercial mortgage REITs such as Starwood Property Trust (STWD), Ladder Capital (LADR), Jernigan Capital (JCAP), and Ares Commercial Real Estate Corporation (ACRE).

These are all commercial mortgage REITs that could continue growing well in a rising interest rate environment. For example, you can see Starwood Property Trust’s favorable cash flow sensitivity to changes in rates below.

Source: Starwood Property Trust Investor Presentation

Commercial mortgage REITs also use less leverage, meaning that their NAVs will decline less due to the decrease in their loan values compared to higher leveraged residential mortgage REITs, such as Annaly Capital Management (NLY).

Source: Annaly Capital Management Earnings Presentation

Since residential mortgage REITs (which invest mostly in fixed-rate residential mortgages) don’t see their cash flow grow when rates rise, especially when short-term rates rise faster than long-term ones (net interest margin compression), a rising interest rate environment can create long periods of decreasing cash flow, dividends, and share prices (which makes profitable growth very difficult).

As a result, residential mortgage REITs are arguably the riskiest kind of REIT to own when rates are rising.

However, just because commercial mortgage REITs are less risky than residential mortgage REITs doesn’t mean they aren’t also higher risk than their equity REIT cousins.

After all, their cash flows are highly tied to the health of the overall economy and their customers being able to continue making their mortgage payments.

During recessions, commercial mortgage REITs can face higher default rates and thus also be forced to cut their dividends.

That’s why most conservative dividend investors are generally better off avoiding mortgage REITs and sticking with high-quality equity REITs such as Realty Income, W.P. Carey (WPC), Public Storage (PSA), and Welltower (HCN).

Interest Rate Sensitivity of Equity REITS
Equity REITs are interest rate sensitive, but you need to keep in mind that not all REITs are created equal.

The REIT industry is incredibly diverse with many different kinds of business models.

The table below shows two important factors to consider. First, certain sectors such as triple net lease REITs (e.g. Realty Income) have very high interest rate sensitivity.

Triple net lease REITs have a high 1.3 interest rate beta. That means that for every 1% increase in interest rates (10-year Treasury yield), the yield on triple net yield REITs increases by 1.3%.

On the other hand, hotel REITs such as Pebblebrook Hotel Trust (PEB) have negative interest rate betas, meaning that they have historically gone up when rates fall.

Source: Hoya Capital

What explains this seemingly strange occurrence? The answer is the business model, or more specifically the underlying length of the contracts underpinning the cash flow and the current bond alternative nature of the REIT industry.

Now that REITs are their own official stock sector, the majority of REIT share prices is determined by institutional capital, mostly mutual funds.

Some of this institutional capital is treating REITs as a kind of bond alternative, and like with bonds, the interest rate sensitivity of the asset is based on its duration.

For example, a two-year Treasury will generally decline by about 2% for every 1% increase in interest rates, while a 30-year Treasury would decline by about 30%.

For REITs, the duration that institutional managers are looking at is the length of the contracts that underpin how often the REIT can raise rent prices.

For example, hotel REITs generally own their properties and obtain cash flow from customers’ nightly stays.

Since hotel room prices change on a daily basis, there is very little inflation risk because room rates can be increased each day.

As a result, the hotel REIT interest rate sensitivity we saw above is signaling that this kind of REIT has low interest rate sensitivity because the duration is essentially 1 day.

On the other hand, triple net lease REITs generally sign very long-term rental contracts with tenants, typically between 10 and 20 years.

While these agreements include annual rental escalators to account for inflation, those are generally based on recent inflation rates. In other words, most triple net lease escalators are very low right now, about 1% to 2% a year.

Should inflation be higher than expected, say 3% to 4% over the length of the contract, then the inflation-adjusted value of the REITs cash flow could actually decrease over time.

Essentially, you can think of the weighted average duration of a REIT’s rental contracts as the duration of this bond alternative. REITs with longer durations and less flexibility to adjust the cash flow rates they receive from tenants are more sensitive to interest rates.

However, it’s also important to note that, as I explained earlier, REIT share prices aren’t entirely based on interest rates.

After all, while the last decade has seen many investors treat REITs as bond alternatives, there is still a big difference between risk-free assets (e.g. Treasury bonds) and equity REITs.

All equities are risky in the sense that the dividends aren’t guaranteed.

If a REIT runs into trouble, say through taking on too much debt right before a recession hits, then it can be forced to cut its dividend during an economic downturn, which happened with many REITs during the 2008-2009 financial crisis.

That explains why the beta of different REIT sectors to the S&P 500 is often the inverse of its interest rate beta.

In other words, while triple net lease REITs are the most interest rate sensitive (in terms of share price and dividend yield), they are also the least volatile REITs you can own.

In fact, triple net lease REITs are generally 60% less volatile than the S&P 500 and 50% less volatile than REITs in general (which as an industry are 40% less volatile than the market at large).

Why is this? Because the very duration of contracted cash flow that affects the REIT’s “duration” also affects its cash flow, and thus dividend security.

For example, a hotel REIT may have very little interest rate sensitivity because it has a duration of just 1 day.

But that also means that hotel REITs have very little cash flow predictability because their AFFO is at the mercy of daily hotel customers.

As a result, their AFFO is the most volatile, and they must maintain lower AFFO payout ratios at the expense of long-term dividend growth.

If a hotel REIT were to grow its dividend too quickly, then the moment the next recession hits and hotel traffic falls, its payout will quickly become unsustainable and require a dividend cut.

This higher dividend risk (and slower dividend growth) explains why hotel REITs are the most cyclical and volatile sector of the industry.

[ad#Google Adsense 336×280-IA]On the other hand, triple net lease REITs, because their rental agreements can last for 20 years, have very steady and predictable cash flow that allows them to generate very consistent and safe dividend growth, often even during recessions (assuming their tenants can still make their payments).

This kind of REIT often attracts more conservative income investors who depend on dividends to fund their retirement.

These shareholders value the cash flow and dividend security above all else.

As long as a REIT’s dividend remains safe, they are unlikely to sell even if interest rates increase.

After all, because a quality REIT will steadily raise its dividend over time, the yield on cost will also rise over time.

Shareholders who bought Realty Income shares back when it went public in 1994 are currently getting paid 30.4% of their original investment each year, for example.

Even adjusting for inflation those shares are still paying an 18.7% yield on cost.

Think of it like this. If you were an investor primarily focused on dividend safety and income to live off during retirement, would you sell a blue chip corporate bond that paid 18.7% and was steadily raising its payout each year faster than inflation just because interest rates increased and the share price declined?

Of course not, because as long as the dividend is secure and growing you are unlikely to have a good reason to sell those shares.

How to Invest in REITs in a Rising Interest Rate Environment
While understanding how and why interest rates affect REIT share prices is helpful, at the end of the day REIT investors really want know how they should position their portfolios in the coming years. Should we make any important changes?

Fortunately, for investors with diversified portfolios, the answer is a very simple and adamant “no.”

Market timing, or jumping in and out of stocks to try to take advantage of or avoid certain situations, has been proven to be the absolute worst thing long-term investors can do.

For example, suppose over the last 90 years you had jumped in and out of the market and missed just the top 10 days of each decade (out of about 17,200 trading days).

Instead of earning 10,055% (investing in the S&P 500), your total returns would have been just 38%!

In other words, market timing is the best way to ensure underperformance and can completely eliminate the wealth compounding power of investing.

The keys to successful long-term REIT investing are the same as the effective habits of successful dividend growth investing:

1) Know yourself, your personality, time horizon, goals, and risk tolerance.

2) Make a well thought out personalized investing plan that meets your needs.

3) Stick to this plan, never investing based on emotions (i.e. flying by the seat of your pants). Failing to plan your investments is the same as planning to fail at investing.

4) Do your research. Never buy a REIT until you’ve checked its long-term dividend track record, including its AFFO payout ratio history. You want to make sure that it’s stable over time and 85% or less (depending on the industry). Also check the balance sheet to make sure that a REIT’s debt levels are safe and that management isn’t likely to be forced to cut the payout during a recession (things like the leverage ratio, interest coverage ratio, current ratio, and credit rating)

5) Stick to your plan no matter what. Buy and hold as long as the investment thesis holds (i.e. the dividend is secure and the business is growing).

6) Add on dips (assuming you have new money coming in).

7) Reinvest the dividends if you can. Dividend Reinvestment Plans (DRIPs) are a potentially great way to automate this process.

Follow this simple plan and you will be well on your way to reaching your financial goals, whatever kind of dividend growth stocks you invest in.

Higher Interest Rates Present Challenges and Opportunities for REIT Investing
While rising interest rates certainly pose a challenge to some REITs, long-term investors with properly diversified dividend portfolios need not fear.

After all, the best quality REITs are led by experienced management teams with plenty of experience growing shareholder value in any kind of interest rate and economic environment.

The key to successful REIT investing is the same as with all dividend growth stocks. Do your research, buy high-quality names at reasonable prices, plan on holding them for the long term, add on dips, and reinvest the dividends.

In the meantime, take advantage of the market’s short to medium-term freak-outs over rising rates to accumulate reasonably priced shares of the best REITs, locking in higher, steadily-growing yields.

While rising interest rates have caused REIT stocks to meaningfully underperform the market since last summer, it’s also important to remember that today’s higher rates are signaling investors’ expectations for stronger economic growth in the future.

Increased corporate spending, a tightening labor market, and greater economic activity translate into stronger occupancy rates, healthy rent growth, and overall stronger fundamentals for most REITs.

At the end of the day, executing a simple investment process, remaining well diversified, and staying the course are the best things a REIT investor can do whether interest rates rise or fall from here.

I plan to continue holding the quality REITs we own in our Conservative Retirees dividend portfolio and will do my best to ignore the interest rate noise that will likely continue making news headlines.

Brian Bollinger
Simply Safe Dividends

Simply Safe Dividends provides a monthly newsletter and a comprehensive, easy-to-use suite of online research tools to help dividend investors increase current income, make better investment decisions, and avoid risk. Whether you are looking to find safe dividend stocks for retirement, track your dividend portfolio’s income, or receive guidance on potential stocks to buy, Simply Safe Dividends has you covered. Our service is rooted in integrity and filled with objective analysis. We are your one-stop shop for safe dividend investing. Brian Bollinger, CPA, runs Simply Safe Dividends and previously worked as an equity research analyst at a multibillion-dollar investment firm. Check us out today, with your free 10-day trial (no credit card required).

Source: Simply Safe Dividends