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Rising Phoenix or Worm Food?  The Future of Real Estate in a High Interest Rate Environment Thumbnail

Rising Phoenix or Worm Food? The Future of Real Estate in a High Interest Rate Environment

by Danielle Woods, Financial Advisor & Attorney

While it is true that REITs are under scrutiny during this unique economic environment, I do not think it makes sense to count them out just yet.  

In a recent webinar, Summer Money Vibes, one of our clients asked a good question.  He wanted to know if the high interest rate environment meant that real estate was a bad investment.    

As always, let’s look at rates in context rather than just this moment in time. The below graph shows average mortgage rates from 1971 through August of 2023 – about a 50 year period.  You can see from the graph that the rates we enjoyed from 2001-2020 are the lowest in the fifty-year period presented.  The historic low occurred around December of 2020/January of 2021.  Over the course of the past 2 ½ years, the purchase of a home with a 30-year mortgage increased to a hefty rate of about 7%. While that number is painful for those of us who have only been buying homes over the past 20 years, you can see that is in line or below the median rate of 7.41%.

Commercial mortgage rates are indeed slightly higher than residential mortgage rates - typically between 0.25% to 0.75% higher. If the property type requires active management - like a motel, marina, or RV park - your commercial loan rate is going to be even higher.

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Of course, we cannot just look at a graph of one economic factor. We are living in a period of competing large dollar costs thanks to high inflation brought on by efforts to combat COVID, the astronomical cost of healthcare, and consumer spending distractions like smartphones and Amazon. To also experience a jump in mortgage rates that hasn’t been experienced before by anyone born after 1970 is a lot to swallow.

What are REITs?

A Real Estate Investment Trust (REIT) is a trust (not a corporation) that owns, operates or finances income-producing properties.  Properties include office buildings, shopping malls, apartments, hotels, resorts, storage facilities, warehouses, and even residential rentals.  As a trust, it has legal requirements, and one of those is to collect the income in the form of rent and distribute at least 90% of its taxable income as shareholder dividends each year.  (Investopedia/REITs)  REITs were created by Congress in 1960, so they have been around a long time. 

Historically, our Propel advisors have invested in real estate via REITs in the form of a mutual fund..  We like REITs because they behave differently than stocks or bonds. They are a great portfolio diversifier that produces income through cash flows, not the underlying value of the REIT itself.  They can act as inflation hedges in a portfolio. They trade like stocks/equities, but they are quite different.

The Changing Face of Real Estate

So how are REITs impacted by rising rates?  The common belief is that REITs are hurt by rising interest rates, since increased costs of borrowing lower the value of the underlying property.  Many investors would rather purchase low-cost, low-risk government bonds if they cannot get a premium over the savings rate from their REITs.  

But that is too narrow a view.  As in all things, the trajectory of interest rates is not the only behavior worth tracking during any economic cycle.  Every period presents its own challenges and responses.  

For instance, I found an older article published in July of 2017 that tackled this issue, titled “The Impact of Rising Interest Rates on REITs.”  You can read the article here.  Co-authors, Michael Orzano, CFA, and John Welling at S&P Dow Jones, stated that while rising rates present a challenge for REITs, they must be viewed in tandem with other economic behaviors.  For instance, rising inflation is actually good for real estate investments because of the increase in their underlying value.

The below graph from that article examines six different periods of rising interest rates to compare REIT performance with the S&P 500 Index (the largest 500 companies in the US).  As you can see, rising rates do not automatically result in declining REIT values.

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The COVID-Induced Office Space Exodus

It would be remiss to ignore the fact that we are experiencing something new in our post-COVID world.  In a very short period of time, an awful lot of people started working from home.  The consequence of that huge change is a reduced need for office space.  While many companies have required employees to return to their physical locations, the rapidly changing need and availability of workers who prefer to work at home has made it difficult to put the requirement into practice.  Even our own team at Propel works remotely, so that we can live where we like and still interact with each other and our clients virtually.

Now the assumption is that we have huge office buildings completely devoid of any purpose. While that was definitely true during the height of the COVID pandemic, we are seeing that same empty office space being repurposed with community use, event venues, and most importantly, data centers.

In Conclusion…

While it is true that REITs are under scrutiny during this unique economic environment, I do not think it makes sense to count them out just yet.  If for no other reason, remain vigilant about the fact that in a capitalist society, one’s loss is often someone else’s gain.  As a student of history and sociology, I am always interested in what humans are doing when faced with adversity.  I think that REITs present yet another opportunity for those who have the capital and the willingness to take risks where others fear to tread.