Financing Focus

Rising Tide

For REITs, rising interest rates may mean a bumpy ride ahead.

The Federal Reserve has a clear message for the market: Buckle up, we're hitting the gas. The Fed's latest rate hike in June 2017 was its third since December 2016, with the goal being to raise the Federal funds rate to  3 percent by 2019. An additional increase is anticipated before the year ends. Currently at 1.25 percent, interest rates today may not be sky high, but they are a far cry from their seven-year stint at 0.25 percent - a rate of effectively zero.

After the prolonged stasis period, the market must now adjust to the changing rate of Federal funds. Real Estate Investment Trusts are among those evaluating the impact of rate increases to their profit margins - with the largest players in the sector factoring in rising interest rates as a risk in the year ahead.

According to the 2017 BDO Risk Factor Report for REITs, 98 percent of REITs cite interest rate increases and their ability to hedge against them as risks to their business. Published in June by BDO USA's Real Estate and Construction Practice, the report examines the risk factors in the most recent 10-K filings of the largest 100 publicly traded U.S. REITs.

Over the course of the study's history, the percentage of REITs referencing interest rate increases as a concern has steadily risen, registering a 10-percent jump to 98 percent in 2017 compared to 2013 at 88 percent. REITs rely heavily on debt to finance their investments, and even a marginal increase in interest rates raises borrowing costs. 

Interest Rate Repercussions

Beyond the direct impact to REITs, higher costs of debt and equity could strain tenants that have benefited from the low-interest rate environment and the availability of cheaper debt. In anticipation of these changing market dynamics, another risk for REITS also has seen a steady increase. The top 100 REITs unanimously cite access to capital, financing, and liquidity as a risk to their business, up from 96 percent in 2016 and 93 percent in 2014.

While REITs may experience a negative impact to their operations in the short term, the Fed's decision to implement gradual rate increases suggests renewed economic confidence, which should benefit REITs in the long term. Strong economic fundamentals historically trigger a positive chain of events for REITs - leading to increased rents and occupancy rates - which could offset the steeper price tag for debt.

A positive impact for REITs is predicated upon whether the forecasted economic recovery is realized, however, and all eyes are on inflation, which is a key economic indicator. The U.S. core inflation rate increased to 1.7 percent this May, but remains at its lowest rate since mid-2015.

As CNBC reported ahead of the most recent rate hike, how inflation evolves will be the X-factor for the market moving forward. Risks related to inflation increased among REITs this year as well, with 52 percent of REITs listing inflation as a concern, up from 42 percent in 2016. The combination of low inflation rates and rising interest rates is likely contributing to widespread uncertainty for REITs.

Tightening capital markets could pose challenges for REITs this year. A silver lining exists for them; the sector has a large pool of capital stored away. In the first quarter of 2017, publicly listed REITs raised more than $23.1 billion in equity and debt. This was the most capital raised in any quarter since the second quarter of 2014, according to NAREIT.

Once REITs adjust to the uptick in interest rates, competition for assets at lucrative prices is likely to eclipse interest rates on REITs' risk radar. The Fed might be hitting the gas on rate increases right now, but its goal is to cruise in neutral. 

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Stuart Eisenberg

Stuart Eisenberg is an assurance partner and the national  leader of BDO's Real Estate and Construction Practice.  Contact him at seisenberg@bdo.com.  

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