This has proven true in 2018 where the Fed has raised rates three times, in March, June, and September by a quarter of a point each time.
The surprise of the three increases along with the uncertainty of future rates has contributed to significant stock market volatility, with October of 2018 being the most volatile October in over a decade.
The fear of increasing rates and the effect on the stockmarket volatility are both a product of perception and reality.
The perception is that higher interest rates will impact the economy from every angle, affecting spending by businesses and consumers and borrowing decisions, corporate buybacks, capital investment, earnings growth and more. Many times, movements in equity prices aren’t necessarily backed by actual economic data. A quarter-point may not affect a corporation’s asset allocations, but the irrational investing public does not always base investment decisions on facts.
Yes, on the one hand, there is the perception that rising interest rates will slow the economy resulting in the exodus of capital from the equity markets.
On the other side, there is the reality.
The reality is that when rates are higher, bond yields look more attractive and investors are enticed to move assets from the equities to debt markets. The other fact is that as the price of borrowing increases the demand for such borrowing decreases. For example, as of October 2018, mortgage applications are down 16% compared to the year prior when mortgage rates were a full point lower.
In times of volatility, the perception is that real estate based equities such as REITs should be less impacted. After all, real estate is a stable long-term investment. The problem is that real estate; although inherently stable, when placed in the hands of irrational players like in a publicly-traded REIT become susceptible to market movements just like all other equities.
Empirical data suggests that REITs are not just vulnerable to market volatility but may be hypersensitive to such volatility.
Since 2008 REITs have proven more volatile than the broader market. This may be caused in part by the REIT business model. Because REITs are statutorily required to distribute at least 90% of its taxable income to shareholders annually in the form of dividends, they are left with little cash in the way of a rainy day fund. Unlike other businesses that are allowed to hoard cash for emergencies, REITs have no such luxury, unable to absorb shocks in downturns.
In a crisis, REITs are faced with two undesirable options for surviving a downturn. One option is to borrow, but with higher rates generally accompanying economic downturns, the cost of borrowing is more costly, putting strains on profitability. The other option is to liquidate assets, the lifeblood of a REIT’s income.
So, in volatile times, REIT investors are assaulted on two fronts. First, share price follows the ebbs and flows of the broader volatile markets. Second, forced to borrow or liquidate assets, the profitability of REITs are negatively impacted, thereby lowering dividends.
REITs as a real estate investment vehicle are inferior to direct or indirect real estate investing for the reasons stated above, especially in an environment of increasing rates, market volatility, and economic uncertainty. Certain types of real estate investing, whether direct or indirect, offers shelter from rising interest rates and market volatility.
Commercial real estate investing mainly provides stability in an economic storm. Unlike residential fixing and flipping, commercial real estate investing is usually done with a long perspective and is less susceptible to investor sentiment.
The higher price of entry also prevents smaller players from jerking prices around. As a hedge against downturns, passive income generated from commercial real estate should continue to produce. Income generating real estate will not suddenly cease providing rental income.
And among all commercial real estate classes, there is one class that has proven its resilience time and again – affordable housing. Affordable housing becomes even more in demand during times of economic hardship. As the cost of home ownership rises with mortgage rates, the need for affordable rental homes goes up.
The renter share of all US households has grown at unprecedented rates in the last decade with that share projected to become even more over the next ten years.
This is because in the past decade, supply has outstripped demand for affordable housing and that gap is currently growing and is projected to grow in the foreseeable future because of Baby Boomers and Millennials – Baby Boomers because of a trend to downsize to conserve capital for a comfortable retirement lifestyle and Millenials looking to reduce their environmental and carbon footprint by going small.
While the rest of the investing public panics over rising interest rates and while REIT investors suffer in a volatile environment, there is one group of investors prepared to ride out the storm because they’ve ridden out every storm previous – commercial real estate investors. Commercial real estate offers shelter from volatility while providing asset-backed income.
Within the commercial real estate asset class, evaluate each sub-sector as they respond differently to Wall Street and the lending markets. Many investors are avoiding retail and multifamily assets due to lower ROIs and stiff competition but they are still investing heavily in commercial real estate. Choose the right fit for your portfolio.