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Momentum Shifting to Later Cycle Office and Retail REIT Property Sectors By Mark Heschmeyer January 28, 2015
Improving property fundamentals across the board are brightening the outlook for REITs going into the year. And yet, just like clockwork, the lingering specter of rising interest rates has some investors on edge.
It was the same worry that plagued the industry going into 2014, but one that never materialized as the overall U.S. economy continued its steady but slow recovery and interest rates remained low.
Now, once again, investors have latched onto concerns over a potential rate increase as the strengthening economy and improved job creation plays into the Federal Reserve’s strategy of allowing rates to rise after the recovery achieves a sustainable level.
The Federal Reserve again this week reiterated its commitment to keep short-term interest rates near zero through midyear, and possibly longer. In a statement released today following a two-day policy meeting by central bank’s Federal Open Market Committee, officials repeated its policy stance:
“To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.”
Based on its current assessment, the committe said it will continue to “patient in beginning to normalize the stance of monetary policy.”
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Readers of Federal Reserve tea leaves believe the bankers have taken a potential rate increase off the table for its March and April policy meetings, but would revisit the topic at its meeting in June.
But like it or not, investor sentiment over interest rates affect REIT stock prices — and weigh directly on REITs’ ability to raise money in the capital markets.
“Over a period of the past two years, 79% of the relative performance of REITs compared to the S&P 500 can be accounted for by the yield on the 10 Year U.S. Treasury and the constant term,” David Shulman, senior economist at UCLA Ziman Center for Real Estate and UCLA Anderson Forecast reported this week. “Indeed, for every 100 basis points in the change in the treasury yield, REITs would either underperform or outperform the S&P 500 by a very large 1170 basis points. For a portfolio manager, this degree of relative interest-rate sensitivity is huge.”
“Real estate is a capital-intensive industry and as such the cost of capital figures prominently in its valuation,” Shulman added. “The typical REIT is far more leveraged than the average industrial company.”
For example, he noted, REITs generally operate with a debt-to-earnings before interest taxes, depreciation and amortization (EBITDA) ratio of 5x to 10x. In contrast, the typical, investment-grade industrial companies that dominate the S&P 500 have Debt/EBITDA ratios of less than 3x.
“For most institutional investors, real estate is viewed as a substitute for fixed-income investments. Other things being equal, (including inflation) the higher the interest rate, the less attractive is the underlying real estate that backs REIT shares,” Shulman explained. “We suspect that those investors who were pleased with the relative performance of REITs in 2014 might be disappointed this year should interest rates begin to rise.”
The cheap money of the last three years has helped REITs lower their cost of debt significantly.
“We continue to exploit the low interest rate environment, while maintaining significant liquidity,” Thomas Olinger, chief financial officer of Prologis told investors just this week.
In the past year, Prologis’ weighted average cost of interest went down from 4.2% to 3.6%. And because of that, the REIT expects to generate 3 to 4 cents per share in growth to funds from operation (FFO) in 2015. That amount would equal a little more than 8% of its latest quarterly total FFO.
When interest rates go up, REITs will have to look for other ways to generate the same kind of growth. And industry analysts project that improvement in overall property fundamentals could make up the difference.
“Heading into 2015, we find investors’ expectations regarding the direction of the rates much more balanced with good reason,” said analyst Ki Bin Kim of SunTrust Robinson Humphrey. “We remain bullish on REITs and think that the search for yield trade remains in place.”
U.S 10-year interest rates offer a comfortable cap rate spread over Treasuries, BBB bonds and foreign interest rates, Kim said, and should continue to spur investor demand for U.S. real estate from global investors. In addition, limited new supply and steady demand growth point to further occupancy and rental rate improvement in the SunTrust Robinson Humphrey analyst’s view.
REITs that invested in and own early-cycle property types, such as hotels, apartments, and self-storage facilities, should continue to post the strongest internal growth in 2015, according to Fitch Ratings.
However, Fitch expects investment growth property leaders to transition this year to later-cycle property types such as industrial, office and retail properties. In part because occupancies and rental rate improvements are accelerating in those sectors, and an increasing percentage of near-term lease expirations involve deals signed at distressed rents during the global financial crisis that are now likely well below market.
Fitch maintains positive property sector outlooks for the office and retail REIT sectors. Accelerating U.S. GDP and employment growth support all property types in 2015. Also office, retail and, to a lesser extent, industrial properties should continue to benefit from low levels of new supply as construction levels remain low, although they have begun trending upwards.
Rent increases for these property types have only recently begun to make development feasible in select markets, and construction lending to these sectors is becoming more widespread.
Fitch expects U.S. office property fundamentals to accelerate during 2015, with most key metrics — demand, supply, vacancy, and rent growth — comparing favorably with recent history and longer term averages.
Editor’s Note: Economists and analysts with CoStar Risk Analytics and CoStar Portfolio Strategies discussed the paths of interest rates at a client conference last November and interpreted the bond market as foreseeing rates staying lower for longer.
A consensus among the CoStar economists expect the Fed would raise later in 2015 than most economists currently expect. The lower-for-longer rate outlook hasn’t changed, and has been reinforced by a further flattening of the yield curve. The 10-year forward yield is below 2.5% in 2020.
As demonstrated in recent market movements, the Fed will be challenged in raising rates when most of the world’s economies are slowing and their central banks are lowering rates.
As the Fed raises, the yield curve will flatten, a possible foreboding of the end of this cycle. Nevertheless, U.S. commercial real estate is better positioned than most other assets for decent returns, particularly in light of rates staying lower for longer, CoStar economist said.
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