9/19/2015 | By Calvin Schnure
The Federal Open Market Committee (FOMC) declined to raise short-term interest rates at its September policy meeting, citing concerns about the potential impact of weaker global growth and financial market turmoil on U.S. economic conditions. It is clear, however, that the days are numbered before the FOMC embarks on the path to higher interest rates; the latest decision merely delays the inevitable. What, then, is the likely impact on the REIT sector of eventual shift to higher interest rates?
Concerns about the potential effects of higher interest rates on REIT valuations have been widely cited as a cause of the decline in REIT stocks so far this year. There are ample arguments, however, that the eventual increase in interest rates may not have a severe or lasting impact on REIT valuations. Recent analysis by EY suggests that rising interest rates may not lead to a lock-step rise in cap rates, as the cap rate spread to the yield on the 10-year Treasury note is rather wide compared to historical averages. A compression of cap rate spreads would allow interest rates to edge up without threatening commercial real estate valuations. This scenario is in line with similar analysis that we have posted on these pages over the past year.
Furthermore, robust improvements in REIT operating performance suggest that Funds from Operation (FFO) and Net Operating Income (NOI) will continue to post strong gains over the quarters ahead. The NAREIT T-Tracker® reported that FFO of all U.S. listed equity REITs was 16.5% higher in 2015:Q2 than one year earlier, and that NOI rose by 12.7% over this same period. Continued gains in NOI will increase the numerator of the cap rate calculations, allowing cap rates to rise organically without any downward pressure on property valuations.
Recent history has clearly demonstrated that the periods preceding an expected change in the Federal Reserve’s interest rate policy are often accompanied by heightened volatility in equity markets, and that REIT share prices are not immune to these concerns. We would not be surprised to see ongoing volatility in the REIT market as long as uncertainty about the future path of interest rates remains high. The steady gains in operating performance, however, indicate that the sector remains on solid ground.