An Urgent Warning For REIT Investors, It’s Time To Buy, Not To Sell
Right now, increasingly many investors are running away from REITs (VNQ) and it has caused them to drop by over 15%:
Most of them are running away from REITs because of one main reason: they fear that rising interest rates will cause REITs to underperform going forward.
The common narrative that you often read online is that REITs should do poorly in a rising rate environment because landlords use a lot of debt to finance their properties and higher interest expenses should lower their profitability. Moreover, rising interest rates could also cause cap rates to expand, which lowers the value of their properties:
Example: A property generating $100,000 of annual net operating income is worth $2,000,000 at a 5% cap rate, but if the cap rate expands to 6% due to higher interest rates, the property will be worth just $1,666,667.
And understandably, investors are scared since the Fed just hiked rates by 50 basis points, the biggest rate hike in decades, and signaled strong commitment for more similar rates hikes later this year.
If we get several 50 basis point rate hikes, the fear is that REITs will crash further, and therefore, you better get out of them before it is too late.
But before you do something that you might regret later, I want to warn you that this common narrative is actually wrong.
Historically, REITs have actually been strong outperformers during most times of rising interest rates. On average, they have generated a 17% return in the twelve months following a rate hike in the past. This is nearly 2x better than the performance of the S&P 500 (SPY):
If rising rates are supposed to lower REIT property values and profitability, how come they’ve been so profitable during past cycles of rising rates?
As is often the case, investors are too quick to jump to conclusions and ignore that the impact of rising interest rates on REITs is much more complex than it may first seem.
Below, we present the three main reasons why REITs have historically done well during times of rising interest rates and why we don’t expect this time to be any different:
Reason #1: Interest Rates Are The Result of Inflation
Typically, interest rates are hiked because of a growing economy and/or inflation, both of which are very beneficial for REITs.
Today, inflation is at its highest level in 40+ years and we are hiking rates to get it back under control. The last reading was over 8%:
REITs own real assets that tend to appreciate in the long run at a rate that’s at least equal, but typically greater than the rate of inflation.
While you can always print more dollars, you cannot print more properties. As construction costs go up, so does the replacement value of existing assets.
Today, there aren’t sufficient new constructions in many property sectors (e.g., housing) due to the high inflation, which makes it riskier to develop new properties. As a result, rents are also rising the fastest in 15 years with double-digit annual rent hikes becoming the norm.
So yes, cap rates could in theory expand a bit to maintain the spread between cap rates and interest rates, but this ignores that rents and replacement values are rising due to inflation.
Moreover, during times of high inflation, the demand for inflation-hedging assets tends to increase as investors want to protect themselves. Therefore, they are likely to accept lower spreads over their cost of capital to get this protection.
For these reasons, property values may still continue to rise even in a rising rate environment. I sure wouldn’t expect prices of real assets to crash in a world of 8%+ inflation and very low interest rates. Remember that despite several 50 basis point hikes, interest rates will still remain very low and deeply negative in real terms.
Reason #2: REITs’ Balance Sheets Are Stronger Than Ever
It is a misconception that REITs use a lot of leverage. This may have been true before the great financial crisis, but REITs learned their lesson since then.
Today, REIT balance sheets are the strongest they have ever been. Leverage is low and importantly, most of this debt is fixed rate and has long maturities.
Therefore, the impact of rising rates really isn’t significant on REITs.
In most cases, there is no impact at all for many years to come, and by then, interest rates may have dropped again.
In any case, the negative impact of rising rates is much lower than the positive impact of high inflation, which increases rents and property values. This is why REITs do so well in times of rising rates / inflation.
Reason #3: Sell The Rumor… Buy The News
Today, REIT share prices are 20% cheaper than they were just a few months ago. On average, REITs are today priced at a lower level than prior to the pandemic, which started over two years ago, and we all know that real estate has experienced significant appreciation since then:
The market has sold off in anticipation of rate hikes, or put differently, it has “sold the news”.
This positions REITs for a strong recovery as the market eventually recognizes that the positive impact of high inflation outweighs the negative impact of rate hikes. Rents are growing rapidly, but interest expenses won’t change materially or at all.
This makes REITs particularly attractive as we go into this cycle of rising rates. They are historically cheap, which provides a margin of safety, and further upside potential going forward.
A Few Top Picks
The broader REIT market may have dropped by 20%, but some individual REITs have dropped by even more than that and are now particularly opportunistic.
NewLake Capital Partners (OTCQX:NLCP) is a new Cannabis REIT that’s on a path to rapid growth. It has increased its dividend every quarter since going public and still hasn’t even allocated all of its IPO proceeds. We believe that it is on a path to ~8% annual FFO per share growth, but you can currently buy it at a near 7% dividend yield. Historically, it has traded at closer to a 4% yield, but the recent 33% dip has caused it to become deeply undervalued.
Medical Properties Trust (MPW) is the largest hospital REIT in the world. Its business is recession-resistant because people need to visit hospitals regardless, and its cash flow is inflation-resistant because it has long 15+ year leases with annual rent hikes and CPI adjustments. Therefore, the high inflation should benefit MPW as it accelerates its organic growth and also inflates away its fixed-rate long-term debt. Despite that, it is down nearly 20%, priced at just 12.5x cash flow, and pays a 6.3% dividend yield. If it can achieve just 3-4% annual growth, investors will earn 10%+ annual total returns from a relatively safe business.
These are just two examples among many others that we are accumulating at High Yield Landlord.
My warning to you is to not panic.
Now is not the time to sell REITs.
Now is the time to buy REITs.
The market misunderstands the impact of rising rates and as a result, REITs have now become steeply undervalued.
We are accumulating them at High Yield Landlord and expect substantial gains in the coming years as REITs recover and while we wait, we earn an average 6% dividend yield.