Increasing Interest Rate on S-REITs
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This post is written on the backdrop of increasing interest rates as US central bank announced a hike of 0.25% with another 2 more rate hikes expected this year.
Many have expressed concerns about the effects of these possible interest rate hikes on investment in Real Estate Investment Trust in Singapore (also known as S-REITs). In the meanwhile, many of you may be wondering how an increase in interest rate affects investment in S-REITs. This post would seek to provide an answer to the abovementioned.
There are 2 ways in which interest rate increase can impact a Real Estate Investment Trust:
- Increase in Interest Expense
In the previous post (https://reitit.org/2018/02/24/how-does-reit-earn-and-spend-its-money/), REIT-it mentioned that interest expense being one of the key expense that takes up between 14 – 19% of the revenue.
Considering that interest expense on borrowings takes up quite a substantial part of revenue, the most direct impact of an increase in interest rate would be the increase in interest expense, which will in turn decrease the dividend distribution to investors should every factors remain the same.
Fortunately in the S-REITs space, many REITs have engaged in hedging policies which allow them to fix their borrowing rates and hence interest expense for a number of years. As such, these REITs, which have fixed their borrowing costs, will not see their expenses rise drastically because of this interest rate hike.
REIT-it have computed some information on the borrowings of all major REITs in the S-REITs space below. Row 3 (% Fixed or Hedged) would tell us the % of borrowings on fixed rate. Row 7 (Credit Score) is a score used by REIT-it to denote the approximate number of years each REIT can continue to enjoy its current low borrowing rate. Those REITs with higher credit score are more resilient in this rising rate environment and hence more preferred.
Commercial REITs Scorecard
Hospitality REITs Scorecard
Industrial REITs Scorecard
Retail REITs Scorecard
Healthcare REITs Scorecard
From the tables above, we can observe that not all REITs are equal and some are more sheltered against the interest rate increase than the rest. REIT-it’s advice would be to look to invest in REITs with better credit score given their ability to enjoy fixed rate borrowing for a longer period of time, and hence would be able to pay out more of their income rather than using the income to pay more interest expense.
Disclaimer: Do note that those REITs with better REIT-it Credit Score does not necessary make the best REIT investment, though the fixed interest rate that they enjoy does give them a huge advantage in giving out better returns on every dollar of revenue. The full analysis would require one to compare also the revenue of each REIT to get a fuller picture on profitability.
- Valuation of Real Estate Investment Trust
The interest rate is a key factor in determining a discount rate for valuation of assets and REITs. If you would like to know more, the discount rate concept is based on the CAPM Model (Can google to find out more).
This valuation concept is built upon the idea that the more risk an investor takes, the more return is required by the investor. The interest rate we have been talking about is called a risk-free rate (return you get without having to undertake any risk). Investment in real estate, stocks and company bonds will all have risks involved and hence investors would want to have returns that are higher than the risk-free rate.
For the purpose of this post, a quick summary would be that as interest rate increases, the discount rate for valuation increases as well. As discount rate for valuation increases, the VALUATION DECREASES.
As such, an increase in interest rate may cause the share price of REITs to drop as investor demand more returns from investing in REITs. The impact on this is unknown as the return requirement has not been consistent across history.
However, it can be noted that an interest rate hike is usually done in the presence of inflation, which is usually a result of increase in economic activities. Rental rates usually rise in a rising rate environment which will in turn mitigate the higher discount rate applied on the valuation of REITs.
Conclusion: On the backdrop of a rising interest rate environment, “cherry picking” while investing in S-REITs is very important. Those REITs with majority of their debt on fixed borrowing rate for a longer period of time would provide the necessary protection against declining return caused by rising interest rate. As such, investors should keep this criteria in mind when selecting REITs for investment over the next 2 years or so.
Hope this post helps you understand a little better on the real impact of rising interest rates. Till the next post…