It’s no secret that the REIT sector has been ravaged by inflation and the surge in interest rates.
Investors have stayed away from this asset class as REIT managers face pressure to maintain distributions in the face of higher debt costs.
However, last week, REITs enjoyed a sharp rebound from their recent lows.
For instance, Mapletree Logistics Trust (SGX: M44U), or MLT, jumped 7.9% in just two days to close at S$1.36.
Frasers Logistics & Commercial Trust (SGX: BUOU), or FLCT, leapt 7.5% to regain the S$1 level.
And Keppel DC REIT (SGX: AJBU) saw its unit price recover 7.6% to close at S$1.99 over the same period.
Income investors may be wondering – what’s happening? Is the worst over and could it be time to dive in to scoop up the battered REITs?
Interest rates and how they impact REITs
Let’s try to understand what’s going on and put things in perspective.
The answer can be found in the US Federal Reserve’s (“Fed”) interest rate policy.
According to the Visual Capitalist, interest rates have been raised at the swiftest pace than at any other time in history.
The Fed hiked interest rates by 4.88 percentage points from 2022 to 2023 to the current level of between 5.25% to 5.5%.
Remember that REITs are very sensitive to interest rate movements as they rely primarily on debt to fund their operations and capital expenditures.
Investors should note that REITs typically do not repay their loans but prefer, instead, to roll them over.
As such, higher interest rates will negatively impact REITs as the new loans will carry a higher interest charge for the same quantum of debt.
With the Federal Funds Rate hovering at its highest level since the Global Financial Crisis, REITs have had to take on increasingly expensive debt.
This has, in turn, pushed down their distributable income and caused distribution per unit (DPU) to fall almost across the board.
With interest rates at current levels, it also makes it tougher for REITs to carry out acquisitions to boost DPU as the hurdle rate (i.e. the returns that REITs need to obtain to justify their acquisition) has also risen.
In short, interest rate increases are a bane for REITs as finance costs rise, resulting in lower distributable income.
A potential reduction in rates
Now that you understand the impact of interest rates on the REIT sector, the next question is to ask why many REITs rebounded so sharply.
The US saw consumer prices rise by just 3% in June, which was lower than expected and provided evidence to the Fed that inflation is slowly coming down to its 2% target.
Also, from May to June, consumer prices fell by 0.1%, the first time it had done so since May 2020.
The slowing labour market is yet another signal that may spur the US central bank to cut interest rates, with the unemployment rate ticking up to 4.1%, the highest post-pandemic and a level unseen since February 2018.
High interest rates not only impact REITs but also heavily indebted businesses and individual borrowers.
A weaker economy and job market are indicators for the central bank to consider lowering interest rates to ease the burden off American borrowers.
Policymakers also spoke of a new assurance that the path of inflation is heading the desired way and expressed confidence that policy could pivot towards a rate cut.
Hence, investors are reacting to the prospect of not just a rate cut materialising in the coming months, but are also anticipating more rate cuts to be implemented than what was originally projected.
Sticking with quality names
Long-suffering REIT investors will view the recent surge as a welcome respite.
The sector has been repeatedly battered by pessimism as interest rates looked to remain “higher for longer”.
The key is for REIT investors to stick with quality names amid the bearish mood.
Look for REITs that boast high occupancy levels despite the headwinds – this metric is an indication of the quality of their portfolios.
Next, find REITs that boast strong sponsors that can help them to not just borrow at more attractive rates, but can also provide a pipeline of assets to be injected into the REIT.
Finally, look for signs of positive rental reversion.
Such instances demonstrate that rental income can still grow organically and also point to sturdy demand for the REIT’s properties.
Get Smart: It ain’t over till it’s over
While the recent surge in share prices was a welcome relief, remember that the Fed’s inflation fight is far from over.
June’s inflation stood at 3% but the central bank’s target is for consumer prices to rise by just 2%.
Also, policymakers rely on a multitude of data to make their policy decisions and will not just hinge on one metric alone.
The coast may not be clear for REITs just yet.
The best action you can take is to stick with high-quality REITs and to slowly buy into them at attractive valuations as you await more news on the interest rate front.
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Disclosure: Royston Yang owns shares of Frasers Logistics & Commercial Trust and Keppel DC REIT.
