After a long period of exceptionally accommodative monetary policy, the Federal Reserve recently restarted the process of raising short-term interest rates to a more neutral range. Expectations of this rate increase and of future changes in monetary policy have at times affected the valuations of many investments, including the share prices of stock exchange-listed equity REITs.
REITs outperformed the S&P 500 with a cumulative total return of nearly 80 percent while the Fed raised its interest rate target in 2004-2006.
Asset prices often decline as the immediate response to a rise in interest rates because higher interest rates reduce the present value of future cash flows, including bond coupons and stock dividends. If future cash flows are not expected to rise, then increasing interest rates would have a clear negative impact on asset values, including the prices of listed REIT stocks.
Changes in the level of interest rates, however, often reflect changes in the level of economic activity. Today’s economic environment, for example, includes several factors that could reasonably be expected to boost future REIT earnings and dividends, even in the context of higher interest rates, helping to support or even increase stock valuations:
- First, earnings of listed equity REITs have been rising. Property occupancy rates could continue to rise if job growth and the overall economy continue gaining momentum, keeping rent growth on an upswing. Further improvements in business fundamentals could increase funds from operations (FFO) and future dividends;
- Second, the Federal Reserve has stated that any decision to raise short-term interest rates will not be intended to slow the economy, but rather to reduce the degree of monetary stimulus. Following a long period of unusually low rates, the Federal Open Market Committee (FOMC) has begun moving towards a more neutral policy, but FOMC members do not anticipate a shift to a restrictive policy of high rates. If the FOMC is viewed as sitting in the driver’s seat, it will be easing off the accelerator, not slamming on the brakes. FOMC members themselves predict only a gradual increase of the federal funds rate over several years;
- Third, history shows that share prices of listed equity REITs have often increased during periods when the Fed shifts from a stimulative to policy stance to a neutral position. For example, listed Equity REITs posted a cumulative total return of nearly 80 percent, outperforming the S&P 500, when the Fed raised its target for short-term interest rates from 1 percent to 5.25 percent in 2004-2006.
The transition to a more neutral monetary policy may lead to volatile share prices in the short term. Thus, it should not be surprising if stock markets weaken from time to time as investors try to sort out the effects of both changing interest rates and changing economic fundamentals. Moreover, the experience from Spring 2013 through mid-2016—when yields on the 10-year Treasury note rose quickly from 1.6 percent to 3.0 percent on concerns about the Fed raising short-term rates, only to fall below 2.0 percent again—counsels some caution in extrapolating higher long-term interest rates far into the future.
If the overall economy continues to expand, generating job growth and robust consumer spending, the key take-away for real estate investment is that the demand for commercial real estate and the resulting growth of rents could support REIT valuations even through periods of volatile markets.