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interest rates and REITS


yadayada
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What happens to interest rates of for example low risk REITs if interest rates go up because the FED influences the markets less?

 

If inflation stays roughly the same, what will happen to for example 5-6% interest rate loans with little risk? You would say that with low inflation, there will always be capital out there willing to borrow for at least close to that rate on a low risk asset?

 

So the only bad outcome would be inflation going up (and thus all interest rates) without ability of those REITS to increase prices?

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Right, so an increase in the general level of interest rates will cause an increase in the market cap rate. If you define Cap Rate = annual operating income/ value, and further breakdown annual operating income into (Rent-Operating Expenses) you get a high level view of the moving parts.

 

Increase in interest rates forces cap rate up due to income alternatives.

Increase in interest rate allows increases in rent due to the higher cost of purchasing as an alternative. Timing depends on current leases, automatic rent increases, etc. Higher costs could also increase vacancy rate due to marginal business failure, etc.

Increase in interest rates due to inflationary pressure (or otherwise, really) increases operating expenses, but decreases real value of debt attached to properties.

Increase in interest rates in the absence of inflation decreases property/asset values, in general.

 

So the answer is a probabilty and magnitude equation that determines whether or not the REIT can increase rents as quickly as cap rates accelerate, property values decline and operating expenses increase. In general, (all other things being equal, which they never are) the price of Equity REITs should be negatively correlated with interest rates in the short-term, but provide moderate inflation protection over the long-term.

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The bigger risk would be their mix of floating-rate versus fixed-rate debt,  I would propose.

 

But as rates rise, increasing FFO will be the main objective, either through rent increases, reducing vacancy, or increasing service revenue. If they have long leases, a high proportion of floating-rate debt, are subject to lockout provisions and are fully leased at current cap rates, I would take a pass.

 

Longer term, I would guess that demographic factors are equally as important.

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