Monday, November 10, 2014

Will Rising Rates Kill Real Estate Funds?

What is to be in store for RE funds and REITs in the upcoming year when the Federal Reserve decides to finally increase interest rates?  I don’t have a magic crystal ball in front of me, but I do have plenty of investing experience and a good foundation in psychology.  Whether investors like to admit it or not, we are all emotional beings, even the great Warren Buffett.  You’ll see here that there is only one thing we can control when it comes to investing for the future, and that is how we respond.  How we “act” is a direct relationship of our emotional and logical state of mind when making a decision.  So before you believe the hype about rising interest rate Armageddon, take a look below.

On October 30th, the Washington Post featured this article by The Associated Press: RE funds needn't be riled...

I’m not one to outright summarize an article.  Why?  You can read it for yourself.  However, I do like to zoom in on key words or sentiments expressed by an article.  To start, notice that the first three sentences include the words, “fears,” “pulled,” “hurt,” and “limit.”  All words with negative connotations for investors.  Did they get your attention too?

You Can Still Get Solid Returns

According to the A.P., provided rates increase moderately, REITs and other assets impacted by rising interest rates, for example, stocks and mutual funds will perform okay.  Investors can expect the hand of the Fed no longer buoying asset prices.  Can investors expect the Fed raising interest rates moderately?  No, we cannot “expect” anything when it comes to the Fed.  However, one has to ask, under what condition would the Fed ramp up, and I mean, accelerate, their activity with rates?  There are two reasons why the Fed would alter interest rates: 1) To stimulate the economy = lowering rates and 2) to curb inflation = raising rates.
Process number one above is done and over with.  That is what the cited article above mentions, namely, that we are seeing a strengthening U.S. Economy, and this is great for not only both you and me, but also for commercial real estate.  Thus, the Fed would only accelerate the pace of rate increases in a scenario where inflation is surging—meaning prices of things are going up because people are buying (high demand) things in droves.  Is this likely to happen next year?  I don’t think so.  Not with wages still low in many states.  Also see: Yellen Pledges Clear Signals...i.e., no mysterious Fed!
I don’t want to make this into an Economics lesson either so…

Here is the drawback: Rising interest rates makes it harder to buy and develop real estate.  Borrowing costs increase!  Money costs more to borrow from banks.  But on the other hand…

When the economy and companies do well, landlords can raise rents, or tenant a property with a higher rent from the get-go.  Dividends would be paid with more security if credit-worthy tenants make their rents with greater ease.  Notice also how the article above focused on REITs of publicly traded companies.  Because the prices of the stock of these REITs change daily, their yields do too.  Dividend per share is a metric that all investors pay attention to.  The dividend per share of any entity that issues a dividend is constant for the year, unless a company fares so well that they decide to increase the dividend.  However, the price of each share (for publicly traded companies) fluctuates in the market daily, therefore, so does the yield = dividend per share/price of the stock.

Don’t be part of the crowd and dump your shares of REITs in the event of rising interest rates next year.  That would be silly.  Settle your emotions and consider what I have shared here in this post and what the cited article from the WP illustrates.  In a nutshell:  
  1. The Fed will be the one to control the rising of interest rates – how much, over what time frame, etc.
  2. The Fed will control this spigot based on underlying economic conditions, namely, improvement and performance.
  3. Due to #1 and #2 above, rising interest rates will correlate to rising economic indicators that will also correlate with rising commercial property rents.
  4. For REITs, rising interest expenses will be offset by their tenants’ rising rents!
  5. Therefore, dividend yield should remain stable, since “bottom line” cash-flow from #4 above should not materially change EVEN IF interest rates rise.

Thanks for Reading!

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