How Will Higher Interest Rates Impact REITs?
If the Fed hikes rates, REITs will be wounded. Higher interest rates boost borrowing costs, which, in turn constrain REITs’ ability to obtain reasonably priced capital to acquire new properties and therefore expand.

Although most experts agree REITs are fairly priced now, they could take a short-term hit if rates rise and investors rapidly exit the sector. Chris Cook, president of Beacon Capital Management, a third-party portfolio manager, asserts that REITs’ strong yields eventually make up for any price dip. “If rates go up, or if there is a real anticipation of rates going up, the price of publicly traded REITs will fall,” he says. “Now to what degree, you never know. You will take a short-term hit on the price, but the yield tends to accumulate fairly fast and starts to make up for any losses over the course of one to two years.”

Yet the impact of rising rates isn’t necessarily all bad for REITs. An uptick likely signals a strengthening economy. If so, commercial real estate benefits because there will be more demand for properties, which increases occupancy and pushes rents—and REIT prices—higher, says NAREIT’s Case.

“All things being equal, REITs should suffer when rates rise due to higher interest costs and a decline in attractiveness relative to other fixed-income investments,” says CFP David A. Schneider, founder of Schneider Wealth Strategies, a New York City-based financial services firm. “But all other things are rarely equal. If rates rise because the economy is stronger, vacancies are decreasing, rents are up and real estate prices are rising, REITs could do well.”

Good Income, But Not A Bond
By law, REITs distribute 90% of their taxable income to shareholders as dividends, which is especially important to investors in retirement looking for a steady income stream. But that doesn’t mean REITs are a viable substitute for bonds.

A high-quality bond typically shelters investors during times of stock market upheaval—something a “risk asset” like a REIT does not, Schneider warns. “Therefore, an increased allocation to REITs to boost yields should come from the equity side of the portfolio,” he says.

Moreover, REIT performance can be volatile, he adds. According to Morningstar, in a recent three-year period REITs have been 41% more volatile than domestic large-cap stocks and four and a half times more volatile than the U.S. bond market.

“That doesn’t mean that volatility will always be the case,” Schneider says. “But sometimes retirees can think that anything with a yield is a fixed-income substitute, and the fact is it is not. But that doesn’t negate its value as a piece of the overall investment pie.”

Somewhere Between Stocks And Bonds
As an investment vehicle, REITs possess characteristics of both stocks and bonds. Because they have a contractual rental stream and because they offer the capital preservation tied to a tangible asset, they mimic bonds, Crowe says. Yet commercial real estate ebbs and flows with the economy. When a lease ends, rents adjust with market realities, meaning those rates can go up or down, giving REITs an equity-like component.

Yet commercial real estate sways to its own rhythm separate from the stock market. According to NAREIT’s Case, the commercial real estate cycle typically lasts about 18 years, while the stock market’s cycle averages four. He estimates the sector is about eight years into its current cycle. “If this market cycle is like previous ones, we still have close to 10 years of bull market ahead of us,” he says.