April 2014 FOMC minutes: Why focus on normalization? (Part 6 of 7)
REITs are driven by two different economic forces right now
Similar to the situation that non-agency mortgage REITs are facing, the commercial REIT sector is driven by economic forces working at cross-purposes to each other.
Interest rates and credit
The REIT sector uses a lot of leverage and tends to sail close to the wind. Given the requirement that these REITs must pay out 90% of their income as dividends, REITs are unable to build up big cash cushions. This limitation leaves REITs at the mercy of the credit markets. REITs use leverage, as the cap rates on various strategies are usually somewhat small. When interest rates increase, their cost of funds increases as well—especially if the increase happens at the short end of the curve.
While the Fed isn’t contemplating increasing the Fed Funds rate any time soon, the financial markets are handicapping when that day will come, and the yield curve includes that forecast by definition. So, even if the Fed has no intention of raising the Fed Funds rate at the March meeting, the markets will still adjust their forecasts and the yield curve will react.
Implications for mall REITs
On the other side of the coin, the Fed will be increasing interest rates due to more robust economic activity. Increasing economic activity will drive more consumption, which is good news for mall REITs. These REITs are still struggling with historically elevated vacancy rates. Consumption has been sluggish as the consumer has de-leveraged, although that may be changing. If so, this is good news for mall REITs like Simon Property Group (SPG) and General Growth Properties (GGP).
Implications for office REITs
Economic strength will be good news for office REITs like Boston Properties (BXP), Kilroy (KRC), Vornado (VNO), and S.L. Green (SLG). They’re still dealing with historically high office vacancy rates, and they want to see more evidence of hiring. That said, there has been very little office building over the past five years, so they could find themselves in a tight market if the economy accelerates better than expected.
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