REITs are supposed to go down when rates move up. Does that mean investors can expect a bounce if they moved too far down?
As interest rates move up, will real estate investment trusts (REITs) get hit or has the market overreacted?
First off, a little fun with math that should help explain the relationship between rates and REITs.
There’s generally a negative relationship between real estate prices and interest rates. Real estate investors price income properties using what’s known as a “cap rate”. Cap rates are the return on investment expected on an income producing property. If a property has a 10% cap rate, investors expect a 10% return the following year on the property.
Since a particular property’s net operating income (NOI) for the following year is a tiny bit easy to forecast, a buyer takes the NOI and divides it by a cap rate and, voila – there’s the property’s value.
How, then, is the cap rate calculated? It’s the required return on the property subtracted by the growth rate. The higher the growth rate in future income, the smaller the cap rate. The smaller the cap rate, the higher the value of the property. Meanwhile, the “required return” is comprised of, among other things, interest rates. Investors need to make more money on their property than the interest rates they have to pay on the mortgage. The higher the required return, the lower the value of the property.
Since REITs are a collection of real properties and higher interest rates on mortgages mean lower property values (all things being equal), REITS should go down when rates go up. All things being equal, of course. But if growth is high enough, it can offset increases in interest rates.
That brings us to the iShares U.S. Real Estate ETF (IYR), comprised of some of the largest real estate investment trusts in America.
Since the start of 2013, the IYR is up almost 4%. However, before May 22, it was up almost 18%. The drop came along with the crisis in Japan and worry over interest rates.
According to Talking Numbers contributor Richard Ross, Global Technical Strategist at Auerbach Grayson, the market overreacted on the IYR and he believes the technicals are indicating it's a "compelling" buy. On the fundamentals, however, Talking Numbers contributor Enis Taner, Global Macro Editor at RiskReveral.com, believes REITs should be avoided.
Who is right? Watch the video above to see Ross and Taner debate whether REITs are the investing in real estate is a real deal.