The impact of rising Interest rates on REITs
Real estate investing is one of the traditional investment options used by individuals to generate income, in addition to investing in gold, mutual funds, and stocks. However, real estate investment is very expensive because we must purchase the entire property before we can rent it out to make money. So, the new way to invest in such properties are through REITs.
Real Estate Investment Trusts (REITs) are the companies who manages the portfolio of high-value real estate properties and mortgages. REITs are governed by SEBI. It makes it possible to invest in real estate and earn dividend and capital appreciation without actually purchasing a property.
REITs functions like mutual funds that are managed by a REIT manager. They rent out properties and receive income and dividends from the rent. Investors can take advantage of this opportunity to increase their capital while also producing income. The entire burden of collecting rental income is taken care of by REIT.
Investors in REITs benefit from fractional ownership, rental and capital appreciation, consistent dividend income, transparency, and liquidity, but there is a market-related risk and no tax benefit due to 90% of earnings must be returned to investors and only 10% can be invested back into the business.
Interest rates have been steadily rising in recent months in order to keep inflation under control, but how do these changes in interest rates affect REITs?
Higher interest rates can affect REITs in two ways. The first is that it makes funding more expensive because most REITs rely on borrowed money to finance the underlying assets, so an increase in interest rate leads to an increase in cost of capital. The second and most significant way is that it compares the REITs return to the risk-free market return, which is the 10-year government bond yield.
REITs, on the other hand, outperform the market in low-inflationary periods. During an inflationary period, REITs tend to hold up quite well because the property value and rent from their underlying assents continue to rise with inflation, allowing us to call it an inflation-protected growth investment.
In case of Mortgage REITs, Mortgage acts very similar to bonds in that it has a steady stream of predictable cash flows but when rates rise the value of that mortgage will fall since its payments are based on old lower rates but on the other hand new mortgages will be issued at higher rate, higher rates will provide higher cash flows for mortgage REITs which should lead to higher valuation so real consideration is speed if rates rises slowly then mortgage REIT managers can manage their portfolio to capitalize on new higher rate mortgages.
Kautilya, IBS Mumbai.