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Don’t Fall for This Real Estate Myth
REITs have gotten a bad rap in rising-rate environments, but historical data tells a different story.
It’s a common misconception that real estate investment trusts — or REITs — underperform when interest rates rise. In fact, REITs can work as a hedge against amplifying inflation, according to TCW’s Iman Brivanlou.
Brivanlou, a managing director who helps manage the Los-Angeles-based asset management firm’s $265.8 billion in assets under management, said the idea that REITs lag when interest rates rise is based on “very linear thinking” that says that as rates rise, the higher cost of borrowing will make it riskier to purchase commercial real estate assets — a phenomenon called capital rate expansion. This line of thinking concludes that the value of REITs relative to the market will go down as the cost of investing in real estate rises.
“What is often missed is that real estate tends to be an inflation hedge,” Brivanlou told Institutional Investor. “More often than not, rates are rising because of some element of inflation, and so REITs can offset that multiple compression through higher rents.”
Brivanlou is not alone in this idea. Morris DeFeo, a lawyer who advises REITs as a partner and chair of the corporate department at Herrick, Feinstein, agreed that increasing interest rates aren’t necessarily an indicator of doom for REITs. He said the view that REITs will rise and fall based on interest rates comes from investors who view REITs as yield plays — or a fairly stable way to generate income. According to DeFeo, this view is “fine” but inevitably “too narrow a view of REITs.”
Other investors view REITs as an opportunity to invest in real estate in a more diversified way. For these investors, interest rates — while still an issue — won’t have as intense of an effect on REIT performance over a longer-term investment horizon.
“If you’re looking at it from the perspective of an investor who wants to invest in real estate, then interest rates are significant… but it’s also an opportunity to take advantage of growing markets and growing earnings as the economy shifts in a certain way and real estate goes along with it,” DeFeo told Institutional Investor.
In a July 2017 report from S&P Dow Jones Indices, contributors Michael Orzano and John Welling found that out of the six sustained periods of rising interest rates that have occurred since the early 1970s, only two periods saw the S&P 500 index outperform U.S. REITs. In four out of the six periods, U.S. REITs earned positive total returns, and in three out of the six periods, U.S. REITs outperformed the S&P 500.
“It is commonly asserted that REITs are destined to underperform when interest rates rise. However, an examination of the historical record suggests that this is a misconception,” Orzano and Welling wrote in the report. “Rising interest rates do not necessarily lead to poor returns.”
Bernie Wasserman, president of Participant Capital, a real estate private equity firm, said the belief that REITs are impacted by rising interest rates is based on the fact that they’re perceived as liquid securities that trade more like stocks and bonds.
“It’s generating an income-based return and that return comes under pressure during times of rising rates,” he said.
Despite this perception, Wasserman said REITs are “hard assets,” and that hard assets tend to perform better in volatile markets over long-term investment horizons.
“Yes, REITs tend to get hit early but they tend to perform well over long periods of time if they’re in assets that tend to perform well,” Wasserman said.
Of course, REITs aren’t the only real estate investment that can protect investors during an inflationary environment. Tom Arnold, a senior advisor at McKinsey and Company, said while REITs may act as a hedge in a high inflationary environment, private real estate investments are more likely to outperform REITs during the same period.