While reviewing my once thriving investment portfolio, I noticed that Omega Healthcare Investors (OHI) and Realty Income Corporation (O) really stood out. These two real estate investment trusts (REITs) have been outperforming the S&P 500, which is surprising considering the common belief that real estate falls when interest rates rise. This is usually because higher borrowing costs can dampen purchasing power. However, let’s delve deeper into why rising interest rates might not be as detrimental to REITs and real estate as one might think.
Understanding Interest Rate Increases
Interest rates typically go up for a couple of reasons. One is a higher appetite for riskier assets in a booming economy, leading investors to switch from bonds to stocks for better returns. Another reason is inflationary pressure from a strong economy, which can lead to higher wages and prices, prompting the Federal Reserve to hike rates to keep inflation around their 2% target.
When the Fed increases short-term rates, long-term rates tend to rise too, affecting everything from mortgage to credit card rates. If these rates climb high enough, investors might shift back to lower-risk assets. But rapid hikes can cause market turbulence, which is why the Fed’s clear communication is crucial.
How Property Values and REITs Respond to Higher Rates
Despite the challenges, history shows that commercial property returns often rise with interest rates. This could be due to the strong demand for real estate outpacing the negative impact of higher costs. Factors like capitalization rate spreads and economic growth prospects also play significant roles in real estate performance. However, political uncertainty and changes in monetary policy can introduce volatility.
REIT Performance During Rate Hikes
REITs have historically done well during periods of rising interest rates. This is illustrated by a NAREIT chart showing nearly two decades of strong performance from 1999 to 2017. The ability of commercial real estate owners to raise rents in a robust economy helps boost returns, especially in sectors with shorter-term leases like multifamily properties where rent adjustments are more frequent.
Challenges and Opportunities with Rising Rates
REITs might underperform when interest rates first start to rise, especially if the Fed’s hikes are more aggressive than expected. However, this underperformance is usually short-lived. Data from Cohen & Steers indicate that three months after a rate hike, REITs have outperformed stocks by 1.5%, and by 7.7% after a year.
Broader Real Estate Considerations
Unlike bonds, where fixed rates make them sensitive to interest changes, REITs benefit from active management that can adapt strategies, such as by growing assets, raising rents, or adding services to increase value. Not all REITs are equal, as shown by the Vanguard Real Estate ETF (VNQ) underperforming the S&P 500. This highlights the importance of choosing REITs with effective management, like those of OHI and O, which have outperformed partly due to positive regulatory changes.
Looking Ahead in a Rising Rate Environment
The contrast between REITs and homebuilding stocks in a rising rate environment underscores the advantages of being a commercial property landlord over a homebuilder. With potential for rent increases and value appreciation, well-managed REITs and real estate investments can offer resilience and even outperform in such climates, provided the Fed remains transparent and gradual in its rate adjustments.
Real Estate for Financial Freedom
Real estate remains my preferred route to financial freedom, offering tangible assets that provide both utility and income. By my early 30s, I had acquired properties that now generate significant passive income, enhanced by strategic investments in real estate crowdfunding platforms during periods of lower valuations.
