Revisiting REITs and interest rates

Chris Bedingfield

Quay Global Investors

With massive fiscal and monetary stimulus now in place, some are now contemplating whether the knock-on effects will be the long-awaited return of inflation.

And rightly so.

We have been inflation bears for some time. However, the sheer scale of fiscal intervention in 2020 does raise the inflation stakes – and therefore even interest rates. So maybe it’s time to re-examine the relationship between interest rates and REITs.

In the past, we regularly cited our analysis showing no long-term correlation between bond yields and REIT returns. The past year has been a big ride to say the least – but considering negative REIT returns despite new lows in global interest rates, we have decided to update our analysis.

Index: FTSE/EPRA NAREIT Developed Total Return Index (AUD)
Source: Bloomberg, Quay Global Investors

The chart above graphs the correlation of 12-month rolling monthly returns of the Global REIT index versus the change in US 10-year bond yields over the same period. A positive correlation means lower bond yields and higher REIT prices. A negative correlation is the opposite. We believe the chart speaks for itself, with no correlation between REIT returns and bond yields over the long term, despite periods of positive and negative correlation. The results appear consistent with different asset classes – the A-REIT sector also has no correlation with Australian 10-year yields over time. The correlation matrix below highlights other cross correlations of note.

Source: Bloomberg, Quay Global Investors

Persisting perceptions

We believe the perception that interest rates influence REIT returns is grounded in two assumptions.

The first is the assumed impact interest rates have on real estate ‘cap rates’. Falling interest rates mean lower required returns: ergo, cap rates for real estate portfolios in the private market fall, leading to higher real estate capital values.

The problem with this idea is that a real estate cap rate is a proxy for ‘real returns’, and therefore more likely to be impacted by a change in real interest rates. Being mostly a commodity, real estate over the medium to long term is driven by the marginal cost of supply. However, the price signal prompts real estate developers to begin supplying the market with new real estate until the point where it is not profitable for them. This increase in supply lowers real estate prices, and this remains the case until supply becomes constrained and capital values begin to recover. We have stylised this market dynamic in the chart below.

Source: Quay Global Investors

The example above is based on an individual asset or portfolio of similar assets. This leads us to the second assumption behind the perception that interest rates influence REIT returns – that listed real estate is simply a composite of static portfolios, with long-dated leases and fixed rental growth.

We know this isn’t the case; our investees are real estate businesses, run by management teams with in-place strategies, managing operating and financial leverage. This means their earnings profiles don’t comply with such a stable, low-growth assumption. And it means most portfolios hardly remain the same. Through a combination of growing portfolios, capital management and leverage, REITs can grow earnings far beyond inflation. We have graphed cumulative earnings growth and changes in leverage for a select number of our investees below.


Source: Company reports, Quay Global Investors

E comes before P

All in all, the best explanation of returns come down to earnings – as it is the source of the initial dividend and it is earnings growth that drives returns. The chart below breaks down equity total returns over the past 120 years between dividend yield, earnings growth and multiple re-rate. The result is interesting.

Data through to 30 September 2019
Source: Ben Carlson, Jack Bogle

It is interesting to note that the past 20 years, when interest rates have mostly declined and central banks have employed significant levels of quantitative easing, PE change has not accounted for much total return at all. Rather, earnings growth and dividend yield has accounted for the lion’s share of returns over the past twenty, fifty, hundred years. In equities – and in REITs, no less – the key to explaining returns lies in company earnings.

Conclusion

As markets continue to navigate the risks of COVID and a potential vaccine, investors are rightly beginning to focus on the risks associated with the massive stimulus put in place during 2020. One of these risks is inflation and the potential for higher interest rates.

But, despite a long-held belief that interest rates influence REIT total returns, there has been a total breakdown in the correlation between REITs and the US 10-year bond yield this year. While there are indeed short periods where correlation is high, over the long term there is no relationship between REIT returns and interest rates.

At Quay, we have found replacement cost and earnings growth have explained REIT returns far better. This makes sense, given REITs are nothing more than real estate businesses operating in a commodity market. With this in mind, we believe it is a better use of REIT investors’ time forming a view on earnings, rather than interest rates. While we have top-down opinions, it is our bottom-up research process that matters.

Investing in global listed real estate

Quay, a Bennelong Funds Management boutique, focuses on the preservation and creation of wealth through innovative strategies in real estate securities. For more insights on global property, visit Quay’s website.

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Revisiting REITs and interest rates 5 It is interesting to note that the past 20 years, when interest rates have mostly declined and central banks have employed significant levels of quantitative easing, PE change has not accounted for much total return at all. Rather, earnings growth and dividend yield has accounted for the lion’s share of returns over the past twenty, fifty, hundred years. In equities – and in REITs, no less – the key to explaining returns lies in company earnings. Conclusion As markets continue to navigate the risks of COVID and a potential vaccine, investors are rightly beginning to focus on the risks associated with the massive stimulus put in place during 2020. One of these risks is inflation and the potential for higher interest rates. But, despite a long-held belief that interest rates influence REIT total returns, there has been a total breakdown in the correlation between REITs and the US 10-year bond yield this year. While there are indeed short periods where correlation is high, over the long term there is no relationship between REIT returns and interest rates. At Quay, we have found replacement cost and earnings growth have explained REIT returns far better. This makes sense, given REITs are nothing more than real estate businesses operating in a commodity market. With this in mind, we believe it is a better use of REIT investors’ time forming a view on earnings, rather than interest rates. While we have top-down opinions, it is our bottom-up research process that matters. For more insights from Quay Global Investors, visit quaygi.com The content contained in this article represents the opinions of the authors. The authors may hold either long or short positions in securities of various companies discussed in the article. The commentary in this article in no way constitutes a solicitation of business or investment advice. It is intended solely as an avenue for the authors to express their personal views on investing and for the entertainment of the reader. This information is issued by Bennelong Funds Management Ltd (ABN 39 111 214 085, AFSL 296806) (BFML) in relation to the Quay Global Real Estate Fund. The Fund is managed by Quay Global Investors, a Bennelong boutique. This is general information only, and does not constitute financial, tax or legal advice or an offer or solicitation to subscribe for units in any fund of which BFML is the Trustee or Responsible Entity (Bennelong Fund). This information has been prepared without taking account of your objectives, financial situation or needs. Before acting on the information or deciding whether to acquire or hold a product, you should consider the appropriateness of the information based on your own objectives, financial situation or needs or consult a professional adviser. You should also consider the relevant Information Memorandum (IM) and or Product Disclosure Statement (PDS) which is available on the BFML website, bennelongfunds.com, or by phoning 1800 895 388 (AU) or 0800 442 304 (NZ). BFML may receive management and or performance fees from the Bennelong Funds, details of which are also set out in the current IM and or PDS. BFML and the Bennelong Funds, their affiliates and associates accept no liability for any inaccurate, incomplete or omitted information of any kind or any losses caused by using this information. All investments carry risks. There can be no assurance that any Bennelong Fund will achieve its targeted rate of return and no guarantee against loss resulting from an investment in any Bennelong Fund. Past fund performance is not indicative of future performance. Information is current as at the date of this document. Quay Global Investors Pty Ltd (ABN 98 163 911 859) is a Corporate Authorised Representative of BFML.

1 contributor mentioned

Chris Bedingfield
Principal and Portfolio Manager
Quay Global Investors

Chris has nearly 30 years of experience working as a real estate specialist, with a background in investment banking and equities research. Prior to co-founding Quay, he worked in real estate investment banking at Credit Suisse and Deutsche Bank.

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