What Happens to Real Estate When the Fed Raises Rates?

What Happens to Real Estate When the Fed Raises Rates?

What Happens to Real Estate When the Fed Raises Rates?

 The Federal Reserve seems likely to raise interest rates in December, barring a collapse in the economy. How will that affect real estate?

Despite its reluctance to raise the federal funds rate in September, the Federal Reserve seems likely to raise interest rates in December, barring a collapse in the economy. In the past, when interest rates have risen, real estate as a whole has tended to underperform, but that may not be the case this time around.

“U.S. real estate will probably trade off a bit [when the Fed raises rates], but Latin America will probably be relatively cushioned against any policy move,” said Jamie Anderson, managing principal of Tierra Funds.

Part of the reason the Federal Reserve, led by Janet Yellen, has been so reluctant to raise interest rates is the effect it would have on global markets, particularly in light of the economic volatility seen in Europe, following Brexit. “The Committee continues to closely monitor inflation indicators and global economic and financial developments,” the Federal Open Market Committee stated in its September 21 release.

 However, not all real estate is likely to be negatively affected, with Mexican REITs, for instance, already trading at a discount due to the weakness seen in the peso.
Latin America real estate over the past 60 days has gained 4% compared to the Real Estate Select Sector SPDR Fund State Street Global ETF (XLRE) , a huge spread that is rarely seen. As such, Anderson has been recommending the Tierra Funds Latin American Real Estate ETF (LARE) to his clients, thinking it can go up between 10% and 15% plus the yield over the next twelve months. Anderson helped create the fund as part of his role at Tierra Funds.

Looking further out, Anderson thinks U.S. real estate, in particular real estate investment trusts, will have more time to adapt and adjust, since the Fed is likely going to take a longer time frame to adjust to normal policy — in this case two to three years — easing the pressure on real estate. “The risk for U.S. REITs is investors may not get the appreciation they’ve seen over the past one to two years — dividend growth will be there and you can get a decent coupon, but there may not be a lot of upside,” Anderson said.

Real estate finally has its own sector in the S&P 500, which gives the $2 trillion asset class a clearer and more transparent way to benchmark. It’s not a one-size fits-all category, and some parts are likely to be less sensitive to a rate hike, chief among them, multi-family real estate.

“Multi-family real estate is going to be a little less reactive to interest rate changes because it’ll provide a better bump in rents as the economy gets better,” Anderson explained. The Vanguard REIT ETF (VNQ) holds residential REITs in its portfolio as well as commercial and specialized REITs. VNQ may also continue to outperform because of its exposure to the industrial economy, which because of the nature of the business, is more closely tied to the global economy and can surpass some of the interest rate-tied headwinds seen in other portions of real estate.

Conversely, areas that are more sensitive to interest rate rises, such as malls, are likely to underperform, Anderson explained, because of “an increase in the cost of capital which will be another headwind for an already struggling sector.”

Other areas around the globe, including the Middle East and specifically Turkey, are quite interesting to Anderson because of young demographics. “Any country that has favorable medium or long term demographics is going to be very good for real estate,” Anderson said.

With US REITs Overextended, Consider this Latin America Real Estate ETF

With US REITs Overextended, Consider this Latin America Real Estate ETF

With U.S. REITs Overextended, Consider This Latin America Real Estate ETF

With attractive REIT opportunities drying up in the U.S., the time is ripe for investors to look overseas, particularly in Latin America, for ETFs providing exposure to emerging market real estate.

These high-yielding, attractively-valued assets are also slated to experience meaningful appreciation given a flurry of tailwinds expected to impact their respective countries. But before we get into why this space presents such a compelling opportunity, we need to take a closer look at the real estate picture here at home.

U.S. REITs Overextended

Real estate investment trusts (REITs) have experienced a sharp rise in demand as a result of their attractive dividend yields and the general appreciation of real estate values over the last five years. Investors have done well to jump on the REIT train with annualized appreciation that has outpaced overall equity returns. However, as the Federal Reserve moves closer to the next Fed Funds interest rate hike against a backdrop of historically high valuations for income-producing real estate in the U.S., are we nearing an inflection point?

Real estate was reclassified last August into its own sector under the Global Industry Classification Standard. With REITs and real estate operating companies no longer grouped into the broad Financials Sector, investors can now properly benchmark companies as well as funds and different industries.

The sector change was long overdue for the $1 trillion REIT category, however, investors must now grapple with the fact that U.S. REIT valuations are at historic highs and are increasingly sensitive to expectations surrounding U.S. rate increases. For example, the widely tracked MSCI U.S. REIT Index fell as much as 5.5 percent when investors fretted over the chance of a Fed rate increase at the September Federal Open Market Committee meeting. But when the committee elected to not raise rates, U.S. REITs promptly recovered nearly all of those losses in the following week.

Given their close tie to U.S. rate policy, the value of U.S. REITs will likely fall when interest rates eventually rise. The good news is we do not necessarily believe investors are going to lose money on a total return basis since the pace of rate hikes is expected to occur over years, not months. However, further appreciation is likely capped and the prospect for dividend growth appears very limited.

Like bonds, many experts believe U.S. REITs are priced for perfection as a result of investor demand for yield, the lack of “risk-free” investment choices and limited global economic growth. Real estate historically has provided investors with both income and appreciation potential. Income is a function of rents, and appreciation is a function of both economic growth and interest rates. In an expansionary economy where growth is robust, the impact of rising interest rates may be offset by strong growth and higher rental rates. But in a low-growth economy, the impact of interest rates is amplified.

What does this mean for the investor who values the predictable income associated with REITs and real estate in general? Does ridding the sector from your portfolio make sense given the current macro environment and medium-term expectation for interest rate changes? We believe the answer is no.

Emerging Market REITs to the Rescue

Real estate is an important low beta source of attractive risk-adjusted yield. But, like a bond portfolio, real estate exposure should be balanced between developed and emerging market (“EM”) real estate, a market which remains in growth mode on the back of favorable demographics and attractive valuations.

U.S. REITs are anything but cheap. The top 10 largest U.S. REITs, with a total market capitalization of nearly $300 billion, currently trade at an average price-to-earnings multiple of 33x, compared to the S&P 500 which trades at 24x earnings. On a price-to-sales basis, the top 10 U.S. REITs trade at an average of 10x sales and 4.5x price-to-tangible book value. Like bonds, the quest for yield has stretched U.S. REITs to historically high premiums over the broader equity market.

On the other hand, EM real estate, Latin America in particular, remains attractively discounted and offers dividend yields that are often superior to U.S. REITs. Notably, interest rates in Brazil are at 10-year highs with REITs yielding 10 percent or more, and many experts believe the central bank will begin cutting interest rates by the end of 2016. If this happens, real estate values will likely rise. Brazilian REITs are cheap, trading at less than book value and price-to-earnings multiples of around 12x, which is in line with the broader local equity market. Mexico REITs also offer attractive dividend yields in the 5 to 7 percent range and trade at roughly 15x price-to-earnings and 0.85x book value.

Apart from the impact of rising U.S. interest rates on domestic REITs, investors should pay close attention to their revenue growth. Analysts expect the top 10 U.S. REITs to see a decline in revenue over the next 12 months. On this factor alone, we believe diversifying into Latin American real estate is warranted. In contrast, Latin American REITs are expected to grow revenue by nearly 30 percent in 2017.

When we launched the Tierra XP Latin America Real Estate ETF (LARE) last December, one of the main goals was to provide investors with diversified access to this expanding asset class. In addition to the inherent benefits of diversification, balance and transparency, the LARE ETF seeks to maximize dividend yield and growth potential by tracking the Solactive Latin America Real Estate Index (LAREPR). LAREPR contains more than 60 components from Mexico, Brazil, Argentina and Chile. Our 20 years of experience working in real estate private equity in the region taught us that regional diversification, combined with the above average yields associated with real estate, is an excellent way to compound capital.

But Latin American real estate isn’t just cheap and high-yielding; it is an excellent risk mitigation tool for broader EM exposure as well. Based on our analysis, the LARE Index exhibits lower volatility than the broad MSCI Emerging Markets Index and significantly less volatility than Brazil and Mexico. Finally, the LARE Index is tracking a dividend yield north of 5 percent on a forward basis which is more than 3x the projected dividend yield for many EM indexes that serve as reference for widely owned EM ETFs.

One potential strategy an investor could employ is to add exposure to the Latin American real estate sector via the convenience of a U.S.-listed ETF to an existing U.S. REIT allocation. The resulting impact would increase exposure to growth potential, diversify sources of dividend yield and offset any potential pullback in U.S. REIT values, without adding unreasonable risk to the overall portfolio.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.