The narrative should be familiar by now.
The US Federal Reserve gets together, and decides to raise interest rates.
Officials are aiming to bring inflation down to the targeted 2% level, therefore interest rates are expected to be high for an extended period.
Here’s what investors may miss.
The increase in interest rates since March 2022 has been the fastest since 1988.
The result?
Real estate investment trusts or REITs have borne the brunt of this steep increase.
Here’s why. As REITs rely heavily on borrowings to fund their asset enhancements and acquisitions, a higher interest rate environment will increase their expenses and crimp their distributions.
Fasten your seat belts
This turbulence is undoubtedly unsettling.
REIT investors have endured a very bumpy ride as investors adjust to the reality of higher rates.
Keppel DC REIT (SGX: AJBU) crashed 14.4% last week after releasing its latest business update as investors digested a sharp year-on-year jump in finance costs.
Many REITs are also trading at their 52-week lows as investors bail out of the sector over fears that interest rates could head higher.
Lendlease Global Commercial REIT (SGX: JYEU) recently hit its 52-week low of S$0.495 while iREIT Global (SGX: UD1U) is also trading at a year-low of S$0.34.
The former has declined by 30% year to date while the latter’s unit price has fallen by 31% over the same period.
Amid the turmoil, it’s easy to lose focus.
As such, it is all the more important to go back to first principles when investing in a REIT.
High-quality assets and tenants
With rates staying high for longer, investors should focus on REITs with high-quality assets and blue-chip tenants.
These two characteristics will allow the REIT to withstand higher finance costs while protecting its rental income.
Well-located, quality properties can retain their value better, allowing the REIT to mitigate any portfolio declines that may trigger loan covenants.
Having a diversified, blue-chip tenant base means that tenants are less likely to go bust and that the REIT is not overly reliant on a major tenant.
Another important factor is a REIT’s sponsor.
A strong sponsor is crucial during times of uncertainty as the sponsor can not only provide financial support should the REIT stumble, but the sponsor can also inject a pipeline of assets to boost the REIT’s asset base and distributions.
By focusing on these traits when investing in REITs, you will not go far wrong.
Looking past the short-term
Of course, the media tends to excessively fixate on the short term.
There is also a tendency to extrapolate the current situation into the future, with investors now believing that interest rates will continue to head up and will stay high for an indefinite period.
But let’s pause and think for a moment.
Remember that all these headlines are based on the current information the financial media reports from the US central bank’s commentary.
Investors may forget that the US Fed Reserve’s moves are dependent on current economic data.
There could be a time in the future when inflation is under control and when high rates start to slow the economy down.
Should this occur, the US Federal Reserve may be forced to backtrack and rapidly reduce interest rates to stimulate the economy.
In other words, these high rates may not be a mainstay for an indefinite period as central banks have the job of constantly calibrating rates to tackle both inflation and slow economic growth.
In turn, REITs will see their time in the sun again when rates are eventually lowered.
Position yourself wisely
Let’s be frank.
The current REIT sell-down is painful.
But as investors, we need to have the patience and fortitude to withstand the turbulence.
If a portfolio is well-positioned and stocked with REITs with great assets and reputable sponsors, then it will be well-placed to ride out this turbulence
2023 is turning out to be an unhappy year for REITs but over the long term, well-managed REITs can do well.
Interest rates may not stay high for too long if the US economy weakens.
There could be better days ahead but it is necessary to hunker down now and wait for this storm to pass.
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Disclosure: Royston Yang owns shares of Keppel DC REIT.