When I last penned my thoughts on real estate investment trusts (REITs) for InvestorPlace, I identified them as a barometer for interest rate movements. In November, they outperformed broader equities, suggesting a top in rates. However, that narrative has shifted dramatically.
REITs have since retraced their steps, eroding any prior gains and breaking new lows.
The uptrend in interest rates casts a long shadow over REITs, primarily due to the well-established inverse relationship between rates and property values.
As borrowing becomes more expensive, so does the cost of real estate acquisition and development. The reverberations of this are felt in property values, putting a squeeze on the profitability of REITs, especially those with variable-rate debt forming a substantial chunk of their capital structure.
With rates on the rise, fixed-income alternatives start to shine brighter. These fixed-income alternatives lure investors away from REITs, because investors typically view REITs as higher risk. This tug-of-war could lead to REITs witnessing capital drainage, adversely impacting their stock prices and limiting their financial muscle for prospective acquisitions or projects.
The REIT landscape further faces sector-specific challenges. Retail-focused REITs reel from the consumer pivot toward e-commerce, diminishing the allure of physical retail spaces. The remote work revolution casts doubt on the long-term demand for office real estate. These trends, alongside stagnant residential home sales, could pressure residential property values, diminishing the asset base of residential-focused REITs and potentially sparking a race to the bottom through increased competition and concessions.
The Bottom Line: Why REITs Matter
Why lay out this bleak picture? Because the trajectory of REITs is intimately tied to interest rate trends. While I maintain an optimistic outlook for the sector over the long haul, the immediate fortunes of REITs may very well hinge on a downward shift in rates or the anticipation of an easing cycle to temper investor concerns.
For those deciphering the Federal Reserve’s next move, my suggestion is to scrutinize the relative strength of REITs against the S&P 500. This measure can be a telling indicator of the financial market’s anticipation of monetary policy shifts.
Should market volatility trigger a flight to safety and a consequent rush into Treasurys in March, the probability of an imminent rate cut increases. In turn, REITs would reap outsized benefits. And it appears we may be on the cusp of such a turn.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
