Why REIT Investors Must Watch Out for Rising Yields

Ser Jing - Why REIT Investors Must Watch Out for Rising Yields (pic)Bond prices have been falling since the start of the year, leading to a rise in yields. Bernanke’s comments last Wednesday regarding a possible slowdown in the Fed’s Quantitative Easing programme in the later part of the year only exacerbated the bond-price declines.

That has led to fears of greater increase in interest rates if and when the QE’s tapering starts. For investors in real estate investment trusts (REITs), that’s definitely not music to their ears.

As a group, the REITs can be represented by the FTSE Straits Times Real Estate Investment Trust Index and it has risen by 52% since the start of 2012 till the end of April 2013. In the same time, the general market, represented by the Straits Times Index (SGX: ^STI), only increased by 25%, signalling much stronger appetite for REITs as compared to other shares.

The REITs have done so well primarily because of market participants’ incessant search for higher incomes to replace dismal interest rates – despite the rise in the FTSE ST REIT Index, its dividend yield at the end of April 2013 was still an attractive 4.8%, much better than the STI’s yield of 2.9%.

But, it seems that things might start to change with the REITs. Let’s take a look at the table below to see how some of them have fared since the start of May 2013.

REIT Price % Change
01 May 2013 20 June 2013
CapitaMall Trust (SGX: C38U) 2.32 2 -13.8%
Ascendas REIT (SGX: A17U) 2.75 2.25 -18.2%
Mapletree Logistics Trust (SGX: M44U) 1.31 1.12 -14.5%
CapitaCommercial Trust (SGX: C61U) 1.71 1.48 -13.5%
Cambrige Industrial Trust 0.86 0.7 -18.6%
Suntec REIT 1.95 1.59 -18.5%

Source: Yahoo Finance

That’s quite a drop in prices for those REITs, especially when the broader market only fell by 7% in the same period.

Now, let’s take a look at the table below, which shows the change in the yields for the 10-year US Treasury Bond as well as the 10-year Singapore Government Securities Bond (a 3.125% note due in September 2022).

Yield Change from 01 May 2013 to 20 June 2013
10 Year US Treasury Yield* 1.63% to 2.42%
10 Year SGS Bond Yield** 1.37% to 2.35%

*Source: Marketwatch (The Wall Street Journal), **Source: Monetary Authority of Singapore

The timing of the rise in yields with the decline in REIT prices is more than just a coincidence. Unlike unsolved crimes, investors in REITs have a clear culprit to lay blame at for their failing investments because rising bond yields does impact the fundamentals of REITs.

And as investors, we can understand the impact from two perspectives.

1. Rise of risk-free yields leads to lesser demand for riskier assets

The 10-year US Treasury Yield is often taken to be a ‘risk-free’ asset. It has been hovering at historical lows in the past few years since the Great Financial Crisis of 2007-2009 as a result of the US Fed’s QE programme.

When risk-free yields are low, investors chase higher yields that can be found in riskier assets (in this case, REITs). When risk-free yields start to rise, the yields that investors demand from riskier assets will have to rise, because investors will want to maintain the same difference or ‘spread’ between the yields they can get from a risk-free and riskier asset.

And, the only way for yields in riskier assets to rise is – you guessed it – for prices to fall.

2. Rise in interest rates makes for a tougher operating environment for REITs

I’ve raised this argument previously (in here, and here). REITs are typically highly levered entities that carry significant debt on their balance sheets. Their business model is such that they borrow money at a low rate and invest it in properties at a higher rate. Rising bond yields would mean rising interest rates, which would increase the costs of borrowing for REITs.

So, when they refinance debt, it’s going to cost them more. Due to the varying durations of the rental leases for the REITs’ properties, they might not be able to pass on the cost increase, leading to a temporary decline in cash flows.

Of course, no two REITs are alike as they deal with different properties, lease durations as well as financing agreements. But, the likely outcome of a rise in interest rates for the majority of them will be a hit to their bottom-line.

Foolish Bottom Line

Investors in most REITs will likely feel temporary pain as interest rates rise. But, that’s not to say that every REIT will be a poor investment. At the very least, those with long-term financing locked in at fixed rates, as well as those with refinancing-needs that are evenly spread out, stand a good chance of coming out ahead of the pack.

Click here now  for your   FREE  subscription to Take Stock Singapore, The Motley Fool’s free investing newsletter. Written by  David Kuo ,   Take Stock Singapore  tells you exactly what’s happening in today’s markets, and shows how you can GROW your wealth in the years ahead.  

The Motley Fool’s purpose is to help the world invest, better. Like us on Facebook  to keep up-to-date with our latest news and articles.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.