As our research has shown, real estate can produce attractive yields even in a rising interest rate environment. In contrast to fixed income investments, it offers yield along with growth prospects. In developed economies and increasingly in emerging ones too, asset managers need to meet the needs of ageing populations and their demand for greater income from their investments.
Listed real estate and higher interest rates
On the whole, there is an inverse relationship between REIT prices and interest rates. Typically, interest rate increases are likely to be met by listed real estate price declines, although this will vary by sector. For example, sectors with shorter lease durations or exposure to a recovering economy, such as apartment landlords and office REITs, can benefit from increasing rates as they tend to indicate that the economy is growing. The relationship between rising rates and the performance of listed real estate is not straightforward, though, as demonstrated by the correlation between the two asset classes which is low on an historical basis. To give two examples of this, the relationship between performance of bonds and that of global real estate securities is weak over the long term, showing a correlation of just 0.11 over the past 20 years. Likewise, the relationship between the 10-year US Treasury bond yield and the US Real Estate index, the MSCI RMZ index since 2005 is also very low, at 0.25. The theoretical explanation for the weak relationship is that as long as higher interest rates are symptomatic of higher economic growth, the impact of a higher discount rate is mitigated by higher expected future rent growth. A comparison by UBS of the listed global real estate sector and US 10-year Treasury yields showed that, as Treasury yields move higher, so too should listed real estate earnings yields. Moreover, as the economy grows, rents should be expected to increase, which adds to the income growth of listed real estate landlords.
Attractive risk-adjusted returns
The performance of listed real estate over the past 20 years stands up to scrutiny. The sector has returned 8.1% annualized over 20 years and 10.3% over 10 years (to the end of September 2013). By way of comparison, investing in general equities and bonds would have returned 7.2% over 20 years and 8.2% over 10 years (annualised). Importantly, real estate can also generate positive real rates of return in inflationary periods. REITs have typically done well during inflationary times for two reasons: 1) rental structures, and 2) by providing a return-on-capital investment style.
Ordinarily, we would expect higher interest rates to be offset by periods of higher growth which can be captured by real estate in the form of higher rents. Although it should be noted that short term shocks in the 10-year Treasury bond yield could cause defensive, interest rate sensitive real estate stocks to drop in the short term (this is what happened in May and June of 2013).
Higher yield than fixed income and equity alternatives
There are few “yield-based” investments on offer globally, and with interest rates so low, global REITs present an interesting investment option. They provide a steady income and offer dividend growth. Looking at listed real estate globally, the sector offers, on average, a spread of 140bp globally, varying from 100bp in the US to 320bp in France and Singapore (as at 30 September 2013).
Clearly, there is a risk that interest rates could be close to a prolonged spike upwards after the 100bp rise in US 10-year Treasury bond yields seen since May. If higher interest rates are accompanied by rising inflation and growth, this can create the conditions for listed real estate to outperform. When the capital markets settle as long-term interest rates move closer to their historical average, investors should bear in mind that including an allocation to global listed real estate can only improve the risk-return profile of their balanced portfolios.
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