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We expect REIT prices to generally move inversely with changes in long-term government bond yields. Although higher interest rates would take some time to show up in REIT financial metrics, eventually higher rates could cause higher debt financing costs, put pressure on traditional after-interest expense measures of REIT cash flow (such as funds from operations, adjusted funds from operations and funds available for distribution) and lead to higher cap rates, which could pressure investment spreads. Also, to the extent that low interest rates have diverted investor funds to REITs searching for higher yield, funds could flow out of REITs if interest rates rise, pressuring commercial real estate and REIT valuations.
Although rising interest rates might signal a strengthening economy, which could benefit real estate fundamentals, we do not expect the macro environment to improve enough to offset what could be another 200-basis-point rise in U.S. government bond yields to levels nearer historical norms.
While the potential negative impact of rising interest rates remains a key concern for REIT investors, U.S. REIT management teams seem less concerned. The majority of U.S. REITs have improved their balance sheets since the last downturn and appear as a group to remain more conservatively leveraged than the last boom in the mid-2000s. Moreover, upcoming maturities for many U.S. REITs over the next few years still carry interest rates that far exceed current borrowing costs, so even a 100-basis-point rise in rates from here would have a negligible impact on cash flow, at least over the medium term.
Nonetheless, recent trading activity suggests that investor expectations about actual or expected future interest rates can have an immediate impact on U.S. REIT stock prices. While we still view the potential for higher interest rates as a valuation risk for U.S. REITs, we would expect higher interest rates to have a negligible impact on our estimates of value. We already embed a mid-4s yield on the 10-year U.S. Treasury bond into our weighted average costs of capital, relative to the mid-2s level observed in the Treasury market recently.
While property remains a business that requires local market knowledge, global capabilities are becoming increasingly important, as capital seeks diversification and opportunity across borders. This global flow of capital is not just cross-border but increasingly cross-continent as well. This, combined with the generally low interest-rate environment, is keeping cap rates low (and property values high), especially for the highest-quality assets in global gateway markets, where global investment flows are especially strong. Global capital flows typically introduce increased competition for property acquisitions, a slight negative for REITs. But global capital flows generally require specialized local-market knowledge for deployment, a boon for the largest global commercial real estate services firms.
Todd Lukasik, CFA, is a senior equity analyst for Morningstar, covering real estate investment trusts (REITs) and commercial real estate services firms. Lukasik has been with Morningstar for nearly 11 years. He was previously a corporate finance consultant for five years and worked in business development for a technology firm for two years. Lukasik holds a bachelor’s degree in economics and political science from Duke University, where he graduated magna laude. He is a member of Phi Beta Kappa and holds the Chartered Financial Analyst® designation.