As its name suggests, REITs are investment trusts that invest in a portfolio of properties in order to generate rental income. Such rental income is dependant on the demand and supply of the property sectors (such as office, residential, industrial, retail and hospitality). Risks and rewards of the properties are then transferred to the unit holders of the REITs.
Typically, a REIT will distribute 90% of its distributable income to shareholders in order to enjoy consequent tax concessions in Singapore.
We are of the opinion that there is a significant relationship between REITs and the prevailing interest rate and we shall explore this relationship further through the analysis set out below:
As REITs rely on debt to finance its property acquisitions, they will incur a higher borrowing cost in the event of higher interest rates. When money becomes more expensive to borrow (due to higher interest rates), it will affect the distributable income of REITs. Hence, to maintain the same yields, REITs will face downward price pressures.
In the event where a REIT depends on short-term debt instead of long-term debts, it will run the risk of having high refinancing costs due to the rise of interest rates. This might also further affect the price of the REIT if it has issues with repayment when the short-term debt is close to maturity because of the increasing amounts of risk it faces.
We can also look at the current ratio of REITs to determine if they have the ability to repay their current liability based on their financial position.
There might be also a risk of capital depreciation due to market sentiment when the interest rate rises. Risk adverse investors might turn to traditional treasury bonds, as they do not wish to assume the risk of capital depreciation in exchange for a smaller spread in the yield.
Due to rising interest rates and borrowing costs, REITs may have to increase the rental rates which may have repercussions on occupancy rates, causing it to fall. This will further impact a REIT’s distributable income and further decrease its yield.
Beg to differ?
There are always two sides to the same coin and people have contrasting and may adopt contrarian views. In a rising interest rate environment, there will definitely be investors who view it as an opportunity to invest in REITs, rather than a warning sign to stay away. REITs might still be a viable alternative for many portfolio managers to achieve a constant stream of regular income and feel that they are fairly valued in the particular market environment.
There is no point worrying about the decreasing prices of REITs in a high interest rate environment, or its increasing prices in a low interest rate environment. What you should be wary about is its risks associated with the change in interest rates.
A REIT is an instrument that focuses on receiving a regular income stream and generally is not intended for capital gain. Investors have to do their due diligence to find out more about the particular REIT they are interested in buying, such as its growth potential, sustainability of rentals, properties’ tenure and lease expiry and so on.
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