Interactive Investor

Why REITs have buckled under rising interest rates

6th October 2022 12:05

Sam Benstead from interactive investor

Real estate investment trusts (REITs) are meant to protect against inflation, so what’s gone so wrong for them since the mini-budget?

Discounts on real estate investment trusts (REITs)  have widen dramatically over the past month in response to investor bets that interest rates will have to rise higher than expected.

Due to a loss of market confidence in UK fiscal policy, financial markets now expect interest rates to hit 5.5% next spring before then coming down by the end of summer 2023.

In response, REITs have plummeted in value. REITs own and manage income-producing property, either commercial or residential. Examples of assets REITs hold include hotels, theme parks and retail sites.

Data from Morningstar shows that over the past month residential and commercial property sectors have moved from about 15% discounts to 32% discounts.

Standout discount swings include: Home REIT, moving from a 4% premium to a 27% discount; Warehouse REIT moving from a 9% discount to a 39% discount; and Urban Logistics REIT moving from a 9% discount to a 33% discount.

For the same reasons (which we explain below) infrastructure trusts have also been affected, with the average trust discount dropping from a 4% premium to a 7% discount. This includes GCP Infrastructure, moving from a 4% discount to an 18% discount and 3i Infrastructure Ord (LSE:3IN) moving from a 13.5% premium to a 3% discount.

Given that one of the main appeals of owning real assets is that their physical property should be able to keep up in value with inflation (and often their income is linked to the inflation rate as well), why has this market sell-off happened?

Higher bond yields

REITs are falling for two reasons: higher interest rates increase the cost of their debt, of which they have a lot, and rising UK government bond (gilt) yields impact how investors value the expected income on offer from REITs.  

A higher “risk-free” return from government bonds decreases the appeal of the riskier returns on offer from REITs. If an investor can get 4% from lending to the government, then taking the extra risk for a 5% yield on a REIT makes less sense.  

Numis, the investment trust analyst, explains: “The so-called ‘headroom’ between gilt yields and property yields has narrowed precipitously over recent months. After the mini-budget, there was less than 0.5 percentage points difference between the UK 10-year bond and a property index.”

Debt problems

Real asset trusts use debt to fund purchases of property. While some of this debt is fixed rate, some is floating rate, meaning that interest payments increase in line with the Bank rate.

Therefore the expectation of further interest rate increases from the Bank of England has direct consequences for the cost of borrowing, which therefore affects profits.

However, Numis says that most property investment companies have a high proportion of fixed-rate debt, and those that have floating rate exposure are increasingly using financial markets to hedge the impact of further rate rises.

For instance, it highlights Warehouse REIT, which took out two £100 million fixed-rate interest loans for three and five years for an estimated cost of £10 million, LXi REIT, which implemented a one-year cap on its £385 million acquisition financing facility, and Life Sciences REIT, which took out a 2% cap on its £75 million loan for an estimated £2.9 million cost.

Most recently Supermarket Income REIT paid £35 million to enter four-year interest rate swaps, effectively fixing the cost of £381 million at 2.84%, Numis adds.

Numis therefore thinks that while the near-term outlook for the sector is difficult, the sell-off has been too severe as markets are pricing in significant valuation declines.

It said: “Aside from a brief period during the onset of the Covid-19 pandemic, the average discount for the diversified UK commercial REIT peer group has not been as wide since the financial crisis in 2008.  

“UK property markets are far less leveraged today than before entering that crisis, when capital declines were also exacerbated by the evaporation of market liquidity. Therefore, we do not believe that property returns will be impacted to anywhere near the same degree as in 2008.”

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.