REITs and Interest Rates: Understanding the Relationship
In the world of finance, interest rates are often described as gravity: when they rise, asset prices must fall. This prevailing assumption has dominated the headlines, painting a bleak picture for the real estate sector. The logic seems simple: higher rates mean higher borrowing costs and lower valuations.
However, for sophisticated investors, this “doom and gloom” oversimplification can create blind spots. The relationship between REITs and interest rates is not a simple linear equation. While monetary policy and the decisions of the Reserve Bank of Australia (or the Federal Reserve in the United States) undoubtedly influence the cost of capital, they do not uniformly dictate REIT returns. The impact varies markedly depending on whether you are holding listed real estate investment trusts (A-REITs or equivalent global indices like the US FTSE Nareit All Equity Index) or unlisted property trusts.
Understanding this nuance is critical. While individual investors often flee the market in fear of rising interest rates, market volatility can often create the best investing opportunities of the decade.
The Mechanics: How Interest Rates Actually Impact Real Estate
To understand the real risk (and opportunity) we must look beyond the headlines at the two opposing forces at play when interest rates move.
The Headwind: Cost of Debt
It is true that commercial property uses leverage (debt). As rates rise, interest expenses increase. If a fund is highly geared, this can squeeze the net asset value and distributable income available for investors. Furthermore, as “risk-free” bond yields rise, the average investor compares property returns against safer fixed income investments, demanding a higher yield from property to justify the risk, which technically exerts downward pressure on capital values.
The Tailwind: Inflation and Economic Growth
However, rate rises are usually intended as a counterbalance to inflation in periods of strong economic growth. This is where the built-in hedge of commercial property kicks in.
Many commercial leases are linked to CPI. This means that as inflation drives up the cost of living, it also drives up your taxable income. If stronger rent growth outpaces the rise in borrowing costs, the asset’s value can hold or even grow, acting as a shield against inflation.
Listed vs Unlisted: A Tale of Two Markets
The vulnerability to interest rate fluctuations implies different outcomes for different vehicles.
Listed (A-REITs): The Volatility Rollercoaster
Equity REITs trade on the stock market. This makes them hyper-sensitive to sentiment. If the RBA hints at a hike, REIT share prices can drop 5% in a single day, regardless of whether the buildings are still collecting full rent. Listed securities have a high correlation with the broader stock market. During rate hike cycles, we often see share prices trade at a massive discount, pricing in a recession that hasn’t happened yet – a disconnect reminiscent of the market dislocation seen during the global financial crisis.
Unlisted (Sentinel): The Strategic Anchor
Unlisted property trusts operate on fundamentals, not sentiment. Their value is based on independent valuations of the physical business assets, not daily market sentiment. This “valuation smoothing” means unlisted trusts do not reprice daily based on anxiety. While they are not immune to macroeconomic conditions, these REITs tend to protect investor capital from the volatility of the stock exchange, allowing you to sleep well at night knowing your position isn’t fluctuating dramatically.
The “Yield Buffer”: Sentinel’s Defence Against Rates
Why do some funds survive rate cycles while others cut dividends? The answer often lies in the “Yield Buffer.”
For illustrative purposes, if a standard equity REITs index tracker pays a 4% yield and cash rates rise to 5%, that investment becomes unattractive. Its price must crash to push the yield up to a competitive level.
Sentinel has a structural benefit here compared to other funds. We target “opportunistic,” high-yielding assets, often aiming for higher levels of distribution. Even in a world where cash rates are 5%, a high monthly income stream remains highly attractive to income-oriented investors. By maintaining a strict Interest Cover Ratio, we ensure the rent collected provides a massive safety margin against rising interest rates, making sense for those seeking security.
The Contrarian View: Why High Rates Are an Opportunity
While most fear rate hikes, the “Sentinel Philosophy” takes a contrarian view: volatility creates opportunities to acquire prime sites and high-value assets for long-term investment gains. Leveraging our in-house expertise and important information gleaned from market research, we can identify attractive assets and optimise acquisition timing in line with our counter-cyclical methodology.
REITs and Rising Interest Rates = Less Competition
When interest rates are low and money is “free,” everyone looks like a genius. Institutional investors bid asset prices up to unsustainable levels. But when rates rise, the competition thins out. This allows cash-rich, active managers to acquire distressed assets for cents on the dollar.
REITS and Falling Rates = Capital Growth
As we look toward the next year, expectations have shifted toward a potential interest rate cut. Buying an asset today at a high yield and low price positions you for a “refinance bonus.” As REITs and falling interest rates eventually converge, borrowing costs will decrease. Investors who enter the sector before the rate cut stand to benefit from significant capital growth as the cycle turns.
Interest Rates and REITs: Don’t Fear the Cycle, Capitalise on It
Investors who flee the sector due to movements in monetary policy may miss the income stability of the unlisted sector. By focusing on high-yielding assets in resilient sectors like industrial, retail, and lodging (tourism), you can build a diversified strategy that thrives in any rate environment.
Whether you are seeking defensive income or positioning for the next phase of growth, Sentinel’s unlisted trusts offer a strategic alternative to the volatility of the listed market.
If you are a sophisticated investor interested in finding out how to capitalise on macroeconomic cycles for reliable, above-market passive income, request an information pack below or explore our current investment options.
Disclaimer: This article is provided for general information only and should not be taken as financial advice. We recommend speaking with a licensed financial adviser to determine whether any investment strategy is appropriate for your individual circumstances.