Real estate investment trusts have provided a welcome refuge for investors trying to avoid the worst of the recent bear market. They posted a total return of nearly 42 percent in the three years ended August 1, 2002, while the Standard & Poor's 500 index fell nearly 31 percent during the same period. But what happens if faster economic growth next year starts to push interest rates higher? Can a rate-sensitive sector avoid getting slammed?
"There's a suspicion that rising interest rates are bad for REITs and falling rates are good," says Mike Kirby, a founder of Newport Beach, Californiabased REIT research firm Green Street Advisors. "But our data indicates that REITs are not more sensitive to rising rates than the typical stock." In 1994, for example, when interest rates jumped 260 basis points, REIT share prices gained just under 1 percent, close to the S&P 500 gain of 1.3 percent. And in 1998, when interest rates fell by nearly 90 basis points, REIT shares declined by more than 18 percent, while the S&P produced a 28.7 percent return.
Gregory Whyte, head of Morgan Stanley's REIT research department and one of the authors of a January 2002 report on interest rates and REITs, agrees with Kirby's point, although he adds a cautionary note. "We don't have data going back very far, so you have to use the findings with a degree of caution," he says. (Most REITs have only been around since 1993.)
The Morgan Stanley study found, among other things, that the direction of long-term interest rates has a stronger correlation with REIT returns than short-term rates do. Two exceptions: shopping mall and apartment REITs, because they often carry sizable exposure to short-term variable-rate debt, which is usually keyed to LIBOR. With short-term rates near a 40-year low of 1.75 percent and perhaps headed even lower, REITs backed by shopping mall and apartment holdings could be vulnerable if interest rates spike a year from now.
Some REITs have taken steps to protect themselves from the potential threat of rising rates. In late June CBL & Associates Properties, a Chattanooga, Tennesseebased regional mall REIT with $567 million of variable-rate debt, converted $407 million of it into fixed-rate obligations. The move increased CBL's interest costs by approximately 350 basis points above its floating rate but substantially reduced its exposure to any future rise in short-term rates.
Santa Monica, Californiabased Macerich Co., a regional mall REIT, is increasing its short-term rate exposure, at least temporarily. In June it announced that it was acquiring Westcor Realty, an Arizona mall operator, for $1.48 billion, including the assumption of $733 million in debt. The debt portion of the deal will initially be financed mostly with variable-rate paper. As a result, Macerich's exposure to short-term rates will temporarily soar from 12 percent of total debt to about 35 percent, according to Macerich CFO Thomas O'Hern.
"We intend to use interest rate caps and swaps to offset a possible rise in short-term rates," says O'Hern. "And our goal is to get our variable debt down to 20 percent fairly quickly."
New Yorkbased Vornado Realty Trust, a diversified REIT, continues to carry substantial variable-rate debt. As of late April, $1.09 billion of its $3.97 billion of debt was variable rate; in the second quarter the variable portion came down only slightly. "I believe interest rates will not rise later in the year," says Vornado CEO Steven Roth.
If he's right, that could spell continued bad news for REIT apartment investors. Their most persistent problem is low mortgage rates, which have made it possible for many renters to buy a home, weakening many rental markets.
Says Lehman Brothers REIT research head David Shulman, "Apartment REITs are likely to be negatively affected this year and part of next by low mortgage rates and weak job growth."