The right REITs don’t need lower rates to win

Here’s how I began “The great REIT reset has begun,” a Wide Moat Daily article from two weeks ago:

It was right before the Federal Reserve announced its latest interest rate decision. And, “like a little girl picking the petals off a daisy, the markets” were “going back and forth about what the” central bank might do “under its new chairman.”

Normally, real estate investment trust (REIT) investors would be especially interested in that kind of question. As I explained:

Now, when I wrote the “great REIT reset” article, they were up 14.6% year-to-date, “a clear step up from the S&P 500’s 9.4% gain. So it seemed that the market was finally realizing they have value beyond Fed policy decisions.

But they’ve fallen ever since, despite how interest rates didn’t even change. While they’re still up 9.5% for the year, the S&P 500 has now officially surpassed them at 13.3%.

So what gives?

One possibility is that the Fed’s July 30 meeting spooked investors. While it stuck with the status quo – and while that decision has since been vindicated considering last week’s unimpressive jobs report – the market seems much more uncertain about what will happen from here.

When it comes to REITs, we don’t really have to wonder how they’ll fair if rates get cut. Share prices will almost certainly go up under those conditions.

But if they rise? Well, that something I’m more than happy to discuss in detail.

First off, let’s discuss the reasons why the Fed’s July decision could have been a mere reprieve. Unfortunately, there’s quite the list, starting with the Middle East.

Geopolitical instability there – specifically in Iran, of course – can affect and is affecting energy prices, which directly affects inflation. There’s the obvious issue of the Strait of Hormuz, which is essentially closed until further notice. So oil shipments just aren’t going through.

But there’s another layer to this energy-inflation relationship. What many people don’t realize is that natural gas is a major component in many fertilizers. Therefore, when the former becomes more expensive, so does the latter… thereby affecting just about every food source and product possible.

One of the Fed’s main goals is to keep that kind of inflation minimized. And raising rates is one of its main tools to do so.

Here at home then, national debt is another problem the Fed needs to carefully consider. It’s getting closer and closer to $40 trillion.

We were at $39.83 trillion at last check, so it’s only a matter of time unless something drastic – and, dare I say, miraculous – happens.

There’s nothing economically significant about $40 trillion, mind you. Once you’re talking tens of trillions of debt, it’s pretty much just mind-bogglingly bad regardless.

But it is psychologically significant, prompting national and international investors alike to zero in (pun intended) on America’s growing interest expenses and enormous Treasury financing requirements.

Already, central banks around the world have been buying up gold at an unusually rapid pace. They’re still buying Treasuries, too, yes. But it appears they’re not as confident as they used to be about the dollar’s reliability.

And you’d better believe the Fed has noticed.

In the same way, it’s all-seeing eye is aware of artificial intelligence’s impact. On the one hand, AI is growing the economy left and right. The scale of its infrastructure needs alone is enormous, benefiting tech companies, construction firms, and utilities, just to name a few.

However, as a direct result of this boom, our financial markets are now filled with enormous expectations. And so any meaningful plot twists to the unfolding AI story could reprice Wall Street in its entirety.

Which, once again, needs to be factored into any Fed decision from here.

If we do get another rate increase, it would automatically open REITs up to further risk. That’s just the nature of any company that’s more heavily dependent on borrowing.

The entire commercial real estate (CRE) sector is sensitive to higher interest rates, but REITs are particularly exposed. Since they must distribute at least 90% of their taxable income to shareholders, they typically retain less cash to fund growth and other capital needs.

That makes access to external capital especially important. So when interest rates rise, the cost of issuing new debt increases, while refinancing existing obligations can become considerably more expensive.

Those are very real factors that definitely affect REITs, but they’re not the entire story. How they’re run matters much, much more.

Not all REITs feel the impact of higher interest rates equally. A company burdened by excessive leverage, lower-quality or poorly located properties, floating-rate debt, and sizable near-term maturities will likely face far greater pressure than one with a conservative balance sheet, high-quality assets, predominantly fixed-rate debt, and well-laddered maturities.

In fact, financially stronger REITs can sometimes use challenging environments to their advantage.

As overleveraged competitors pull back on investments and development, competition for attractive opportunities declines. At the same time, financial stress can push more properties onto the market, allowing well-capitalized REITs to acquire quality assets at more attractive prices.

In other words, a difficult environment can widen the gap between the strongest operators and the weakest – and give disciplined REITs an opportunity to play offense while others are forced to play defense.

Yes, the cost of financing those purchases is higher. However, so are the prospective returns – sometimes by a lot.

So instead of asking if the Fed will raise rates, the real question should be, “Does this REIT have what it takes to prosper regardless?”

Ultimately, we just don’t know what our central bank will do from here. Some might say that’s especially true with Kevin Warsh at the helm, but don’t forget about 2021 under Jerome Powell.

There was every reason for him to raise rates nearly the whole year long. Yet he just kept talking about “transitory” inflation for months on end.

We also don’t know where oil prices will be six months from now… how geopolitical relationships will be… or how far the AI trade will have moved one way or the other.

The future is filled with unknowns, leaving us to evaluate the present as best as we can.

If that sounds defeatist, it’s not. I’ve made a successful career and built my finances back from ruinous losses to multi-millions based on doing exactly that.

So I know it works to focus first and foremost on bottom-line balance sheet details such as:

Those factors tell me far more about a REIT’s future than trying to guess the Fed’s next move.

The best REITs aren’t built around a particular interest rate forecast. They’re built to survive (and ideally thrive) across interest-rate cycles.

That’s the difference between a REIT that needs the Fed to come to its rescue and one with the balance sheet, competitive advantages, and management team to turn uncertainty into opportunity.

I know which one I’d rather own. How about you?

Happy SWAN investing!

Brad Thomas
Editor, The Wide Moat Daily