Saturday, February 2, 2019

REITs Part II: Interest Rates

This is the second part of my analyses of REITs. Refer to Part 1 here.

The first part deals with the components of a dividend yield, where I mentioned that the risk-free rate sets the base for a REIT's dividend yield. In this post, I will focus on this component, as it is a long term driver of REIT yields as a sector.

Brief history of interest rates. Broadly speaking, as REITs trade like junk/high yield bonds, changes in government bond yields generally drive dividend yields. Institutional investors like pension funds, insurance firms, asset management companies and even central banks, tend to perceive REITs relative to government and corporate bond yields, especially since the Global Financial Crisis of 2009. Recall that at the height of the financial crisis, the Federal Reserve brought its policy rate to an unprecedented zero percent. Even with that, lending activity remained depressed and total loans in the system fell as US households deleveraged after the property bubble burst.

While short term interest rates were close to zero, longer-term interest rates remained somewhat higher. This led the Federal Reserve to embark on a series of government bond buying sprees. This entailed the central bank going into the government bond market, and buying bonds using what was essentially digital money created out of thin air. This was known as the Quantitative Easing (QE) program.

The net result of several rounds of QE led to lower bond yields and a lot more cash in the financial system. Note that while the official interest rate (Fed Fund Rate) and the US 2-year government bond was at 0%, the 10-year and 30-year government bond yields declined steadily between 2010 and 2015. This was a direct consequence of the Federal Reserve purchasing more than USD 2 trillion of US Government bonds under its Quantitative Easing program. (technical way of saying that the Federal Reserve 'printed' USD 2 trillion and bought government bonds). Naturally, by pushing down the 10 and 30-year government bond yields, this results in lower borrowing costs for companies that are issuing long-tenure bonds and even individuals seeking mortgages.

If you thought low bond yields are already bad enough, other major economies of the developed world, namely Europe and Japan took this unconventional monetary policy to new heights, by pushing interest rates and government bond yields into negative territory. The goal of this radical monetary policy was to lower borrowing costs so as to stimulate economic activity, but the side effect was inflation of asset prices globally (primary beneficiaries were stocks and real estate).

In case you were wondering, a bond with a negative yield does not mean a negative coupon. It just means that the bondholder will eventually receive his principal upon bond maturity that is lower than his initial purchase price, with the coupons collected insufficient to compensate for that difference.

How does this tie into REITs? Institutional investors drive global markets. They run the gamut from hedge funds, family offices, banks, treasury desks of large corporations, to central banks and sovereign wealth funds. They all have varying degrees of risk appetites and investment horizons, but of interest to us are what are known as 'Liability Driven Investors' (LDIs). LDIs are basically investors that make investment decisions with the primary goal of meeting future liabilities. Classic examples of LDIs are pension funds and insurance firms, who must invest not with the primary goal of short term profits, but must generate returns to meet expected payouts in the present as well as remain solvent for the distant future.

Think about your own personal insurance policies (perhaps life, or even medical insurance) from the perspective of your insurer. Your insurance firm must be able to generate sufficient returns from its portfolio not just to meet a claim anytime between the present and decades from now, but generate profits to satisfy its own shareholders at the same time. As such, LDIs typically rely on stable but low volatility investments to meet its ongoing obligations. In the pre-crisis era, bonds constituted the bulk of an LDI's portfolio. However, zero/negative interest rates and very low bond yields have made traditional LDI asset allocation very unsuitable for obvious reasons. This has led to LDIs allocating more assets to stocks in a bid to generate better returns, and REITs have been a natural alternative to bonds owing to their relatively stable dividend yields. It is this relationship that has transformed REITs into a quasi-junk bond investment class.

The relationship between the government bond yield and REITs is more apparent in the large-cap and liquid REITs as they are most likely to be held by institutions as opposed to their counterparts that are less liquid or of smaller REITs. The chart below shows the dividend yield of CapitaLand Malls Trust (CT) and CapitaLand Commercial Trust (CCT), as compared against the yield of a 5-year Singapore Government Bond (SGB). While not perfect, there is a reasonably strong correlation between the movement of dividend yields and bond yields. For the mathematically inclined, the correlation factor between these REITs and the 5-year SGB is between 0.6-0.7. 
From the chart above, we can see that the two REITs trade at a fairly constant premium to the SGB, in what is the risk-premium that investors receive for taking on risks as described in Part 1. Here, we can see with clarity that movements in the underlying bond yields are a causative factor behind changes in the REITs' dividend yields. Bearing in mind that dividend yields are a function of DPU dividend by a REIT's unit price, dividend yields can only respond to a change in SGB yields through a change in unit price. Therefore, if bond yields were to rise sharply suddenly, dividend yields would follow suit, but only through a fall in unit price. 

It is through this mechanism that we can see why REITs tend to perform poorly in periods of rising bond yields, despite the broader stock market faring well. Likewise, falling bond yields globally since late 2018 has translated in a broad based REIT rally, simply because REIT dividend yields are falling, tracking the underlying fall in bond yields. 

So when do REITs generally perform well? The sweet spot where most REITs outperform or perform as well as regular stocks is in a 'goldilocks-like' situation of modest economic growth. In this climate of lukewarm growth and business sentiments, central banks tend to keep interest rates low and monetary conditions easy. On the other hand, strong economic growth usually means higher interest rates, such as the US in 2017-18, which led to bond yields rising and ultimately hurt REITs globally. On the other hand, recessionary economic conditions will also hurt REITs in general, as vacancy rates can be expected to rise and rental rates fall (as how certain industrial REITs were impacted in the aftermath of the crude oil price plunge in 2014). REITs with a more resilient lease structure (longer leases, defensive sectors such as healthcare) will generally perform better in this environment as bond yields will fall.

So far I have only touched on the market aspect of dividend yields and bond yields/interest rates. Bond yields also affect a REIT's fundamentals in terms of its interest expense, since all REITs are leveraged. Rising interest rates will result in lower DPU, holding all else constant. Since REITs have the ability to take out bank loans or issue bonds, rising interest rates and bond yields will generally affect their interest expense.

Also, interest rates feature heavily in the calculus of acquiring new assets. The REIT manager will have to factor in the prevailing cost of debt (interest cost) plus cost of equity, if the REIT has to raise fresh equity. Should the cost of debt and/or cost of equity be higher relative to the yield of the asset-that-is-to-be-acquired, the deal will end up to be DPU dilutive. Therefore, interest rates can and do impact the viability of new assets. Generally, a lower interest rate makes an acquisition more viable. Investors familiar with the S-REIT space would have taken note that S-REITs have been exploring aggressively in Europe over the last few years. It is also no coincidence that interest rates in the Eurozone are very low, making it viable for REIT managers to borrow in EUR and purchase yield-accretive assets there.

Therefore REITs are generally very sensitive to interest rates (more so than stocks in general) as rising interest rates will have a two-fold effect:

  1. Market effect - rising bond yields means that the REIT's dividend yields are pressured to rise (higher dividend yield implies lower REIT price)
  2. Fundamental effect - rising bond yields translates directly into higher interest expense (lower DPU). A lower DPU compounds the market effect described above, since if dividend yields are rising, and DPU is falling, the unit price must fall by a larger quantum. 
A simple example to demonstrate this is with a hypothetical REIT with a DPU of 6 cents and a unit price of $1.00. This translates into a dividend yield of 6.0%. Let us assume that interest rates were to rise by 0.50%, and that this hypothetical REIT's market dividend yield follows suit. The outcome are as the following:


Here, we can see how rising interest rates are a double-whammy for REITs. Conversely, in the same example, if interest rates were to fall by 0.50% instead, the unit price would rise to $1.09 just accounting for the immediate market effect. A higher DPU of 6.5 cents, due to lower interest expense would work out to a unit price of $1.18.

Please note that the calculations above are purely hypothetical as the Fundamental Effect depends on the REIT's debt profile. If the REIT has a debt profile of long-term fixed rate loans or bonds, the interest costs will not be impacted by short term fluctuations in interest rates. In this case, the timing of when the REIT has to roll over its debt is critical. On the other hand, a REIT with a larger exposure to floating interest rates will see greater variability in its interest expense. Clearly, the examples above assumes that the REIT's debts consist of floating rate loans and bonds (perhaps tied to the SIBOR)

Interest rates and bond yields are the tide that lifts and lowers the REITs as a sector. A REIT investor ignores the broader environment of interest rates, to the peril of his portfolio. Knowing this will help you to understand why REITs tend to sell-off even if the broader stock market is not. Or why REITs seem to participate in a stock rally at times, and at other times, remain on the sidelines.

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