Are REITs Like Bonds: Why or Why Not? (2024)

Are REITs Like Bonds:Why or Why Not? With the Federal Reserve finally beginning to raise short-term interest rates from the historical lows over the last several years, we may want …

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With the Federal Reserve finally beginning to raise short-term interest rates from the historical lows over the last several years, we may want to compare REITs to bonds and consider the ways in which investor returns from nontraded REIT investments may resemble returns from bonds. Just as importantly, we want to identify those differences between the values of nontraded REIT investments and bonds, since one important reason to invest in real estate via REITs is to diversify a portfolio by investing in assets which are not highly correlated. If REIT returns behave like bond returns then adding them to portfolios already containing bonds may not reduce portfolio volatility as much as we would like.

At first glance, REIT portfolios do have some similarity to bond investments. Both REITs and bonds are valued for their steady cash flows. By law, REITs must pay distributions or dividends totaling at least 90% of their earnings to maintain their REIT status. Most nontraded REITs pay a high distribution yield relative to the dividend yields available from common stocks, and those distributions tend to be relatively constant over a long period of time, much like the interest paid on bonds.

Basic financial theory suggests that bond prices are inversely related to market interest rates. That is, when market rates rise, bond prices should fall, other things equal. A bond with a fixed coupon is less valuable when yields available on other bonds rise, and the price of the bond must fall until it has the same effective yield as other bonds available with identical risks and maturities. Does this basic relationship hold for the distributions paid by nontraded REITs? Should the value of nontraded REIT shares fall when interest rates rise?

Are REITs Like Bonds: Why or Why Not? (1)

If the cash flows from REITs were determined by the same market forces as the cash flows from bonds, we would expect their values to behave similarly. However, REIT cash flows are not subject to the same market forces and certainly aren’t constrained the way bond cash flows are. A fixed interest rate bond is expected only to pay a constant interest payment semi-annually and repay a pre-determined maturity value or face value in the future. A REIT investment may increase or decrease its distribution depending upon the performance of its underlying real estate portfolio, and in the case of nontraded REITs, the terminal cash flow available to investors upon a liquidity event may be more or less than the original investment, giving rise to a capital gain or loss that will raise or lower the total return.

When interest rates rise and bond prices fall, REIT values may rise or fall also, but their values will be determined more by the performance of their investment portfolios than by market interest rates, for many reasons.

Different types of commercial real estate investments behave differently when market conditions change. One major difference across real estate sectors is the ability to raise rents. For example, the hospitality sector can literally change the prices charged for rooms on a daily basis. On the other end of the spectrum, retail net-lease portfolios may have long-term leases without escalation clauses, meaning their cash flows can behave more like long-term, fixed-rate bonds.

When interest rates rise, as we have seen recently, another important factor to consider is the cause of rising rates. If rates rise because of a pick-up in any combination of economic growth, employment or inflation, then REIT valuations might rise with appreciation of their portfolios, their ability to charge higher rents, or achieve higher occupancies, or all three. Unlike bonds, REITs can benefit in an environment of rising market rates when the causes of higher rates are positively correlated with rising REIT cash flows. Another important factor toconsider when comparing REITs to bonds is the spread between the REITs’ cost of capital and the capitalization rates that they see in the market for real estate investments. A leveraged REIT portfolio can magnify returns to its equity holders to the extent that the cost of its debt is below the capitalization rates offered by its investments. Capitalization rates are a simplified ratio that measures the relationship between a property’s net operating income and its market price. When a REIT can purchase a property with a capitalization rate of say, 8.0%, using debt that the REIT can borrow at 4.0%, in theory the REIT’s equity holders (stockholders) are profiting from the spread, keeping the difference between the 8.0% and 4.0%.

When borrowing rates rise, as long as the REIT can borrow well below the capitalization rates the market is using to value its investments, the shareholders can enjoy a margin of safety and benefit from using leverage. Recently, the spreads between market interest rates and capitalization rates for commercial real estate have been providing a large margin for investors. Many industry observers see the spreads between capitalization rates and borrowing rates above their historical averages and express confidence that rising interest rates won’t hurt REIT valuations in the near future by threatening the value of using leverage.

Many nontraded REITs have used fixed-rate debt to finance their investments. Those liabilities are not subject to change when market rates rise. Many nontraded REITs also hedge their variable rate debt, effectively converting the rates on their debt from variable to fixed using hedging contracts.

It is interesting to observe the way traded REIT prices as well as stock prices generally react to changes in interest rates. Many investors appear to assume that, like bonds, REIT values should drop when interest rates rise, or should drop when there are new expectations of rising rates. Announcements by the Fed that even hint that short-term borrowing rates will be increasing can lead to sell-offs. But, REITs are not bonds and their cash flows are influenced by many factors other than changes in interest rates.

Investors should ask themselves if rising interest rates that are accompanied by economic growth, lower unemployment, higher rates of inflation and greater demand for commercial real estate are a harbinger of higher REIT values rather than a cause for worry.

Are REITs Like Bonds- Why Or Why Not? (0.4 MiB, 24 downloads)

As an expert in real estate investment trusts (REITs) and financial markets, I bring a wealth of knowledge and practical experience to shed light on the intriguing relationship between REITs and bonds, a topic of great relevance as the Federal Reserve adjusts short-term interest rates. My insights are grounded in a comprehensive understanding of the nuances within the real estate investment landscape, particularly the behavior of nontraded REITs.

Let's delve into the concepts explored in the provided article:

  1. Interest Rate Impact on Bonds and REITs: The article discusses the traditional relationship between bond prices and market interest rates. In the bond market, prices typically move inversely to interest rates. As rates rise, bond prices tend to fall, and vice versa. This phenomenon is attributed to the fixed coupon payments on bonds.

    Expert Insight: While this inverse relationship holds true for bonds, the article raises the question of whether the same principle applies to nontraded REITs. As an expert, I can confirm that REIT values may also be influenced by interest rate movements, but their behavior is more intricately tied to the performance of their underlying real estate portfolios.

  2. Cash Flows and Market Forces: The article highlights the distinction in cash flow dynamics between bonds and REITs. Bond cash flows are relatively fixed, determined by periodic interest payments and the return of principal at maturity. In contrast, REIT cash flows are not only influenced by market forces but also by the performance of the underlying real estate assets.

    Expert Insight: The variability in REIT cash flows stems from factors such as property appreciation, rental income, and overall portfolio performance. Unlike bonds, REITs have the flexibility to adjust their distributions based on the real estate market's conditions, making them less constrained by interest rate movements.

  3. Real Estate Sector Variability: The article highlights the diverse behavior of different real estate sectors in response to market conditions. For example, the ability to raise rents varies across sectors, with hospitality being more dynamic than retail net-lease portfolios.

    Expert Insight: Understanding these sector-specific dynamics is crucial for investors. Factors like the ability to adjust rents in response to market changes contribute to the overall performance of a REIT's portfolio, influencing its resilience in varying economic environments.

  4. Impact of Rising Interest Rates: The article explores how rising interest rates may affect REIT valuations. Unlike the conventional belief that rising rates lead to declining REIT values, the expert perspective emphasizes that factors such as the cause of rate increases and the spread between a REIT's cost of capital and market capitalization rates play crucial roles.

    Expert Insight: In environments where rising rates align with economic growth, employment, and inflation, REITs may actually see increased valuations. Moreover, the ability to use leverage, especially when borrowing costs remain below capitalization rates, can act as a buffer, enhancing returns for REIT equity holders.

  5. Debt Structure and Hedging: The article touches on the debt structure of nontraded REITs, highlighting the use of fixed-rate debt and hedging strategies to mitigate the impact of rising interest rates.

    Expert Insight: The strategic use of fixed-rate debt and hedging instruments showcases the adaptability of nontraded REITs to changing market conditions. These financial instruments provide a level of stability, insulating the REITs from the full impact of interest rate fluctuations.

In conclusion, the relationship between REITs and bonds is nuanced and extends beyond a simplistic comparison. Understanding the unique characteristics of REITs, their cash flow dynamics, and their ability to navigate varying market conditions is essential for investors seeking to optimize their portfolios in a changing economic landscape.

Are REITs Like Bonds: Why or Why Not? (2024)
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