REITs and interest rates: Welcome back my friends to the show that never ends - UBS
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19 October 2021, 4:01PM UTC
Chief Investment Office GWM
Investment Research
REITs and interest rates: Welcome back my
friends to the show that never ends
Real estate markets
Author: Jonathan Woloshin, CFA, Real Estate & Lodging Analyst Americas, UBS Financial Services Inc. (UBS FS)
.
• Although REITs are likely to react negatively to
rising bond yields in the short term, we believe the
relationship between REITs and bond yields over the
longer term is much more complex and nuanced than
many might think.
• We analyzed nine periods between 1995 and 2018
where 10-year Treasury yields rose more than 100
basis points. REITs outperformed the S&P 500 in
four instances and underperformed in five. A deeper
dive of these periods of out- and underperformance
yielded a number of crucial considerations for
investors as they evaluate REITs in a rising rate
environment.
• A crucial part of the REIT–interest rate calculus is that
different subsectors have specific dynamics that can
respond to specific economic conditions. In addition,
it is important to factor in a REIT's average lease
duration when making sector allocation decisions,
particularly in periods of rising (or fear of rising)
interest rates.
• The composition and the individual company and
subsector weightings of the REIT indexes have
evolved significantly over the years. Company and
subsector leadership has shifted substantially as
certain sectors fell into or out of favor and new sectors
emerged. This has had a significant impact on the
REIT–rates relationship.
• In our view, there is not one single correct answer
as to how REITs will perform in a period of rising
bond yields. We believe there are a number of
considerations that will ultimately impact how REITs
perform in periods of rising rates, which we detail
within the report.
The volatility surrounding the trading in REIT shares pursuant the name of the 1973 world tour by progressive rock
to moves in 10-year US Treasury yields is reminiscent of superstars Emerson, Lake & Palmer, entitled "Welcome Back
This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and
disclosures at the end of the document.Real estate markets
My Friends To The Show That Never Ends." It should come Fig. 3: Actual and relative REIT performance during
as no surprise that over the longer term, REIT shares have select periods of rising bond yields
generally had an inverse directional relationship with 10-
year yields (Fig. 1).
Fig. 1: REIT total returns and 10-year Treasury
yields, 1995 to 8 October 2021
Source: FactSet, SNL Financial, UBS
As the data in Fig. 3 indicates, of the nine periods
we analyzed when bond yields rose, REITs outperformed
Source: FactSet, SNL Financial, UBS the S&P 500 four times by an average of 648bps, and
underperformed the S&P 500 five times by an average of
However, what can be quite confusing to REIT investors is 2,599bps. There are several periods in Fig. 3 that we believe
the negative reaction of REIT shares over a shorter time warrant a deeper discussion.
frame to relatively small increases in bond yields (Fig. 2).
• The period between October 1998 and January 2000
As the data in the figure indicates, the 30bps increase
was the heart of the tech bubble. Hard assets, value
in 10-year yields between 9 September and 10 October
stocks, and anything that did not have even the remotest
2021 resulted in a fairly sharp sell-off in REIT shares. This
dotcom affiliation was cast aside in favor of any and
phenomenon has led a number of REIT investors to conclude
all things technology. As such, we do not believe rising
that rising rates are unequivocally negative for REIT shares.
rates were the main culprit behind REITs' significant
underperformance.
Fig. 2: REIT price returns and 10-year Treasury
yields, 20 September to 11 October 2021 • Despite bond yields rising 131bps between 24 June 2005
and 23 June 2006, this was a period of significant capital
inflows into the REIT sector as well as an uptick in REIT
M&A. These factors were significant enough to allow the
sector to overcome a rise in rates, in our view.
• The period of 19 December 2008 to 2 April 2010
coincided with the beginning of the post-global
financial crisis (GFC) recovery. Although bond yields
increased 182bps, we believe this increase was more
than overwhelmed by the combination of globally
coordinated central bank liquidity measures, a thawing
of the global capital markets, increased REIT access to
capital, and the beginnings of a robust global economic
Source: FactSet, SNL Financial, UBS recovery following the severe contraction experienced
during the GFC.
The preceding notwithstanding, we believe the relationship
• The period of April 2013 to January 2014 is commonly
between REITs and bond yields over the longer term is much
known as the "taper tantrum," though it actually began
more complex and nuanced than many might think. We
in May 2013. It was in late May 2013 when then
analyzed nine discrete periods between 1995 and 2018
Fed Chair Ben Bernanke announced that the Federal
when 10-year Treasury yields rose by more than 100bps,
Reserve was considering tapering the quantitative easing
with the exception of one case when the increase was only
(QE) program that had been put in place during the
88bps (Fig. 3).
GFC. The announcement caught many investors by
02Real estate markets
surprise, and 10-year yields moved from 1.6% to 3% are a good proxy for the shifting dynamics of the sector
very quickly. Despite the fact that considering ending composition over the years.
the QE program should have been a signal that the
economy was improving—something that is positive for This growth of the infrastructure REITs is an important
commercial real estate—we believe the speed of the rise development in terms of assessing the potential future
in rates overshadowed what ultimately proved to be a impact of rising (or falling) bond yields on overall REIT
rapidly improving economic outlook. performance. On one hand, the infrastructure REITs, in our
view, have more of a secular growth outlook given their
• Although bond yields rose 183bps between 1 July 2016
underlying demand drivers for data and wireless solutions.
and 5 October 2018, several REIT subsectors, including
On the other hand, as these REITs are considered more
industrial, hotels, and residential performed quite well
technology- and growth-oriented, they are more likely to be
despite the overall REIT sector lagging the S&P 500 by
valued via discounted cash flow analysis. This differs from
more than 4,000bps. The hotel industry was in the midst
more traditional real estate valuation for the more cyclically
of a continued strong recovery cycle; the benefits of e-
oriented traditional commercial REIT subsectors, which tend
commerce were shining through in the industrial sector;
to be based on multiples on funds from operations (FFO),
and the residential sector was benefiting from a solid
dividend yields, and premium or discount to net asset value.
multifamily and manufactured home market as well as
As such, the infrastructure REITs could be more susceptible,
the nascent but growing single-family rental market.
particularly in the shorter term, to rising yields. We believe
Conversely, malls and shopping centers were extremely
this was a significant contributor to the recent REIT sell-off
poor performers as the pace of retailer store closures and
despite the modest 30bps increase in bond yields.
bankruptcies began to accelerate.
The final bullet point above highlights another crucial A reasonable question for investors to ask, given that
part of the REIT–interest rate calculus—that is, different the REIT indexes are more heavily weighted toward the
subsectors have idiosyncratic dynamics that can respond infrastructure REITs, is: Are REITs destined for continued
to specific economic conditions, such as hotels in 2016– underperformance if bond yields continue to rise? Although
18, or lease duration impacts, as demonstrated by the this is an extremely challenging question to answer,
dramatic underperformance of the healthcare sector in we believe the answer will be largely influenced by a
2013. Healthcare real estate facilities tend to have longer combination of factors, including how much yields rise, how
lease durations as compared to other property types. fast they rise, and will revenue and FFO growth of the
As such, it is important to factor in lease durations to infrastructure REITs be sufficient over the longer term to
one's investment process when making sector allocation overcome the potential headwinds of rising yields.
decisions, particularly in periods of rising (or fear of rising)
interest rates. In Fig. 4 on page 5, we highlight the We recognize that this analysis potentially raised as many
performance of eight REIT subsectors for the nine periods questions as it answered. That is certainly one of the things
of rising rates referenced previously in Fig. 3. that makes security analysis so fascinating. In our view, there
is not—and we believe the historical data supports this—
If all of the above were not enough, the composition and one single correct answer as to how REITs will perform
the individual company and subsector weightings of the in periods of rising bond yields. We believe there are a
REIT indexes have evolved significantly over the years. In number of considerations that will ultimately impact how
Fig. 5, which begins on page 6, we highlight the top 50 REITs perform in periods of rising rates, including, but not
equity REITs by market capitalization between 1995 and 13 limited to:
October 2021. As can be seen in the data, company and
• How fast are rates rising? As we saw during the 2013
subsector leadership has shifted substantially over the years
taper tantrum, the very rapid rise in bond yields caught
as certain sectors fell into or out of favor—think industrial
investors by surprise. We believe REITs might be better
versus malls, or self-storage versus hotels. In addition, a
positioned to weather a slow upward grind in rates far
new sector of infrastructure REITs composed of wireless
better.
towers and data centers emerged post-GFC. These REITs
have grown substantially in market capitalization over the • Why are rates increasing? Recall that commercial real
past several years and are now among the largest capitalized estate is an economically sensitive asset class. If rates are
equity REITs across the various indexes. rising due to an improving economy and are grinding
their way higher, as opposed to gapping up, we believe
In Fig. 6 at the end of the report, we highlight the top 50 many REIT subsectors can perform well in such an
equity REIT capitalization as a percentage of the total equity environment.
REIT capitalization between 1995 and 2021. As the data
• The shape and driver of the shape of the yield curve
indicates, the top 50 REITs are a substantial percentage of
during a rising rate environment can have a significant
REITs' overall market capitalization. As such, we believe they
03Real estate markets
impact on REIT performance. Some of the strongest REITs could benefit at the margin from more attractive
REIT returns between 2000 and 2019 have occurred relative earnings growth.
when the yield curve was in a bull cycle. In a majority
of the cases when the driver of the shape of the yield
curve was either a bull/flattener or a bull/steepener, REITs
demonstrated positive absolute returns.
• How readily available is equity and debt capital? Is
the unsecured bond market open, and how wide are
spreads?
• Subsector selection is crucial. As we discussed previously,
lease duration can play a role in subsector performance.
Some property types including healthcare, office
buildings, and triple net lease tend to have longer
lease durations and, depending on economic conditions,
could lag in a rapidly rising yield environment.
• What is the absolute level of rates? We believe this is a
crucial question, particularly over a longer period of time.
Current 10-year Treasury yields are approximately 1.6%.
A 40bps move in yields on its face would be significant.
That said, at a 2% 10-year yield, REIT dividend yields
and implied cap-rate spreads would, in our view, remain
appealing to both institutional and individual investors
who are in need of yield.
• Related to the above point: What will the flow of
institutional capital into the REIT market look like in a
rising rate environment? The past several years have
seen more pension funds, sovereign wealth funds,
and insurance companies increase their allocations to
publicly traded REITs as well as private commercial real
estate. As long as rates remain below the levels required
for these institutions to achieve their targeted returns
with a more traditional asset allocation, it is certainly
possible these investors could increase their allocations
to public REITs.
• Will REIT M&A continue? The past 12 months have
experienced a significant level of both REIT-to-REIT and
REIT-to-private-equity M&A, as a number of public REITs
sought to enhance their geographic, leverage, and G&A
profiles while private equity sought to capitalize on the
combination of its significant dry powder and a number
of REITs trading well below consensus net asset values.
• How well capitalized is each REIT, how well laddered are
their debt maturities, and have they taken advantage to
lengthen their maturities and lower and fix their debt
costs? We believe those REITs that have taken this path
will be better positioned in a rising rate and inflation
environment.
• Will there be unfavorable tax legislation that could draw
money away from the REIT sector? Although impossible
to answer currently, this is clearly a topic that bears
watching. In the event that corporate tax rates rise and
the REIT structure remains status quo for tax purposes,
04Real estate markets
Fig. 4: REIT subsector performance during select periods of rising bond yields
Source: FactSet, SNL Financial, UBS
Fig. 5: Top 50 equity REITs by market capitalization, 1995 to 13 October 2021
Source: NAREIT, SNL Financial, UBS
05Real estate markets
Fig. 5 (continued): Top 50 equity REITs by market capitalization, 1995 to 13 October 2021
Source: NAREIT, SNL Financial, UBS
06Real estate markets
Fig. 5 (continued): Top 50 equity REITs by market capitalization, 1995 to 13 October 2021
Source: NAREIT, SNL Financial, UBS
07Real estate markets
Fig. 5 (continued): Top 50 equity REITs by market capitalization, 1995 to 13 October 2021
Source: NAREIT, SNL Financial, UBS
08Real estate markets
Fig. 5 (continued): Top 50 equity REITs by market capitalization, 1995 to 13 October 2021
Source: NAREIT, SNL Financial, UBS
09Real estate markets
Fig. 5 (continued): Top 50 equity REITs by market capitalization, 1995 to 13 October 2021
Source: NAREIT, SNL Financial, UBS
10Real estate markets
Fig. 5 (continued): Top 50 equity REITs by market capitalization, 1995 to 13 October 2021
Source: NAREIT, SNL Financial, UBS
11Real estate markets
Fig. 5 (continued): Top 50 equity REITs by market capitalization, 1995 to 13 October 2021
Source: NAREIT, SNL Financial, UBS
12Real estate markets
Fig. 5 (continued): Top 50 equity REITs by market capitalization, 1995 to 13 October 2021
Source: NAREIT, SNL Financial, UBS
13Real estate markets
Fig. 6: Top 50 REITs % of total REIT capitalization, 1995 to 13 October 2021
Source: NAREIT, SNL Financial, UBS
14Real estate markets
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