Real estate investment trusts (REITs) are companies that own, operate, or finance income-generating real estate. REITs offer investors a way to access the real estate asset class without having to buy, manage, or finance any properties themselves. REITs typically pay out high dividends from the rents or interest they collect, making them attractive for income-seeking investors.
However, REITs are also affected by macroeconomic factors such as interest rates and inflation. These factors can influence the demand and supply of real estate, the cost of capital for REITs, and the valuation of REIT shares. In this blog post, we will explore how interest rates and inflation impact REIT performance and whether REITs are a good inflation hedge.
Interest rates and REITs
Interest rates are the cost of borrowing money. They affect REITs in two ways: by influencing the cost of debt financing for REITs, and by affecting the discount rate used to value future cash flows from real estate.
When interest rates rise, the cost of debt financing for REITs increases. This reduces the profitability and cash flow available for dividends. Higher interest rates also make alternative investments such as bonds more attractive relative to REITs, which may lower the demand and price for REIT shares.
However, rising interest rates are not always bad for REITs. Sometimes, interest rates rise because of strong economic growth and rising inflation. These conditions can boost the demand and occupancy for real estate, allowing REITs to raise rents and increase their revenues. Higher inflation can also increase the replacement cost of real estate, making existing properties more valuable.
According to a research report by S&P Global1, there have been six periods since the early 1970s when 10-year Treasury yields rose significantly. In four of those periods, U.S. REITs earned positive total returns, and in half of those periods, U.S. REITs outperformed the S&P 500. The report suggests that rising interest rates are associated with other factors that positively affect REIT fundamentals, such as economic growth and inflation.
Inflation and REITs
Inflation is the general increase in the prices of goods and services over time. It affects REITs in two ways: by eroding the purchasing power of future cash flows from real estate, and by increasing the value of real assets such as real estate.
When inflation rises, the value of future cash flows from real estate decreases in real terms. This lowers the present value and price of REIT shares. Higher inflation also increases the opportunity cost of holding REITs, as investors may seek higher returns elsewhere to keep up with inflation.
However, rising inflation can also benefit REITs if they can pass on the higher costs to their tenants through rent increases. This can protect their cash flow and dividend growth from inflation erosion. Moreover, higher inflation can increase the value of real assets such as real estate, as they tend to appreciate faster than nominal assets such as cash or bonds.
According to a blog post by Nareit2, REITs have historically outperformed during periods of above-average inflation. The post shows that since 1972, U.S. REITs have delivered an average annual total return of 11.9% when inflation was above its long-term average of 3%, compared to 10% when inflation was below its long-term average.
Are REITs a good inflation hedge?
An inflation hedge is an investment that can maintain or increase its value during periods of high inflation. Based on the historical evidence, it seems that REITs can be a good inflation hedge under certain conditions.
REITs tend to perform well when inflation is driven by strong economic growth and demand for real estate, which allows them to raise rents and revenues. However, REITs may struggle when inflation is driven by external shocks such as oil price spikes or supply chain disruptions, which increase their costs but not their revenues.
REITs also tend to perform well when inflation is moderate and expected, which allows them to adjust their leases and financing accordingly. However, REITs may suffer when inflation is high and unexpected, which reduces their real cash flow and valuation.
Therefore, whether REITs are a good inflation hedge depends on the source and magnitude of inflation, as well as the ability of REITs to adapt to changing market conditions.
REITs are companies that own, operate, or finance income-generating real estate. They offer investors a way to access the real estate asset class without having to buy, manage, or finance any properties themselves. However, REITs are also affected by macroeconomic factors such as interest rates and inflation. These factors can influence the demand and supply of real estate, the cost of capital for REITs, and the valuation of REIT shares.
We have seen that interest rates and inflation can have both positive and negative effects on REIT performance, depending on the underlying causes and consequences of these factors. REITs can benefit from rising interest rates and inflation when they are associated with strong economic growth and rising rents. However, REITs can suffer from rising interest rates and inflation when they are associated with external shocks or unexpected surges.
Therefore, whether REITs are a good inflation hedge depends on the source and magnitude of inflation, as well as the ability of REITs to adapt to changing market conditions. Investors who are interested in REITs should consider the different types and sectors of REITs, their exposure to interest rate and inflation risk, and their dividend yield and growth potential.
REITs can offer investors a way to diversify their portfolios, generate income, and hedge against inflation. However, they are not immune to market fluctuations and macroeconomic uncertainties. Investors should do their own research and due diligence before investing in REITs.
Meet Krishnaprasath Krishnamoorthy, a finance content writer with a wealth of knowledge and experience in the insurance, mortgage, taxation, law, and real estate industries.