In an era of rising rates, proponents of sectors like Utilities and REITs which are perceived to be interest rate sensitive can only offer two arguments in their defense: (i) interest rates (on the long end) aren’t going to go up much further or (ii) the afore-mentioned sectors aren’t really negatively impacted by rising rates. On September 25 last year, the Federal Reserve Bank of San Francisco published a paper titled Demographic Transition and Low US Interest Rates by Carlos Carvalho, Andrea Ferrero and Fernanda Nechio which proposes that a change in life expectancy higher is leading to a greater propensity to save rather than spend, putting a downward pressure on the natural rate of interest. Of course, there is no unanimity of opinions on what r-star is. In a Q&A session with Judy Woodruff of PBS on October 3, FOMC Chairman, Jerome Powell stated, “Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral. We may go past neutral, but we’re a long way from neutral at this point, probably.” Keep in mind that policy error by the Chairman could lead to an overly restrictive monetary policy, leading to below potential GDP growth (and lower interest rates on the long end anyway).
In the June issue of Green Street Advisors’ monthly missive, Heard on the Beach (do people really talk about REITs on the beach?), Mike Kirby and Peter Rothemund suggest that REITs have become materially more prone to interest rate sensitivity since 2012. They write, “The sea change has been remarkable from a statistical perspective, as a previously non-existent relationship (from ’98 – ’11) between changes in Treasury rates and relative performance has morphed into one that is now very strong. Since ’12, a 100 bps upward move in rates has corresponded with a 1400 bps underperformance by REITs (vs. S&P 500), and vice versa.”
The most logical explanation for the shift in relative performance is a change in ownership composition; as more and more REIT shares fall into the hands of generalists and passive funds, prices have become untethered from underlying real estate values. Without effective intermediation by dedicated REIT funds, the narrative of interest rate sensitivity has ruled the roost, interrupted sporadically by buying interest from private equity. Never mind that cash flows and dividends for REITs are growing alongside the rest of the economy and that inflation leads to higher construction costs and lower supply. Unless the makeup of the shareholders changes in the near future, expect discounts to NAV to persist longer than in the past and dedicated funds and their clients will actually have to hold true to their stated investment horizons (hopefully longer than one quarter) in order to achieve a favorable outcome from both an absolute and relative perspective.