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What higher interest rates mean for your REIT investments

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Tony Paolone – JPMorgan Senior Analyst and Co-Head of U.S. Real Estate Stock Research, joins Yahoo Finance Live to discuss how REITs are faring amid the pandemic and share his outlook on the real estate sector.

Video Transcript

BRIAN SOZZI: With the return to offices delayed for many due to the pandemic and yields on the rise, the REITs sector could be in the spotlight very soon. Let's dive in with JPMorgan Senior Analyst and Co-Head of US Real Estate Stock Research Tony Paolone. Tony, good to see you this morning here. So, for those not necessarily too familiar or invested in the REITs space, historically, what has happened to the sector when rates rise, as they have over the past month?

TONY PAOLONE: Yeah, it's a good question, Brian. So, we don't have a lot of examples, because interest rates have been going down for such a long time. But, you know, one example was the taper tantrum, where you had a pretty hard and fast move in rates that surprised the market, and during that period of time, the REITs did take a hit. We were down about 15% over the course of, say, four months, and underperformed the market in that instance. So I think there's a lot of focus on that as an example of the risk to the group right now. But from our vantage point, we do think there's some key differences where that doesn't necessarily have to be the case this time, because there's a lot of other good things that are happening across commercial real estate right now.

JULIE HYMAN: I would also ask, Tony-- hey, it''s Julie here-- what the debt load is of REITs in aggregate now, compared to historical levels, and I imagine the debt servicing costs, even if, I don't know, even if rates go up another 25 bps, for example, that it's still going to be relatively low for these guys.

TONY PAOLONE: Yeah, from a capital stack point of view, and thinking about the debt and the debt loads of these companies, that's really a non-issue from where we sit. The leverage levels for REITs run approximately 30% of total real estate value, so these are pretty low-leveraged vehicles as it relates to commercial real estate. When you go to the private market, and you see participants buying commercial real estate assets, the leverage level is typically about double that. So, from that vantage point, the companies are in very good shape. The interest rate risk, from our vantage point, has more to do with whether or not it prompts investors to seek other parts of the market and sell stocks that have been historically geared towards more income-oriented investors. That's the bigger risk to us. We're not too worried about the capital stacks themselves. In fact, what you're seeing across the group right now is balance sheets that are in good enough shape to see broad-based transaction activity. So being able to use balance sheets to drive growth through investing has actually been a positive for the group.

BRIAN SOZZI: Hey, Tony, it does appear that we're going to stay in this hybrid work environment for some time to come. How does that change the earnings power of the REITs sector, looking out over the next five years?

TONY PAOLONE: Yeah, well, we think it's a headwind for the office business, clearly, and we can all debate about whether 5% of people work from home or 50% of people work from home. There will be some amount of it that happens. We do think it will be some amount of a headwind to demand for office space. So we think the office business is most at risk, naturally, from this shift in the way people work. So our view has been to deemphasize office stocks. But there is a really interesting way, we think, to invest in the theme broadly, and that is through the commercial real estate service companies, where they're going to have a seat at the table here to help occupiers manage their space, whether they want more or less of it, and they're going to get paid commissions and advisory fees, almost irrespective of how the world ends up playing out from a space point of view. They're going to be in the mix helping occupiers and landlords with space decisions, and we think that's the way you invest in the shift in what's happening in workplace usage.

JULIE HYMAN: And, Tony, is Jones Lang LaSalle an example of that, that you're trying to play the servicing side of the business?

TONY PAOLONE: Yeah, that's exactly right. It's our top idea right now. We think that's a company, it's the number-two commercial real estate services platform in the world, and you've got the ability to drive earnings growth, over the next few years, through the return of transaction activity, both investment sales, which have been effectively doubling on a year-over-year basis, and the return to more normalized leasing activity. Going back to this office idea, through the pandemic, a lot of office leasing decisions have been delayed, and companies, again, still need to figure out precisely what they want to do with their space over time. Those deals will happen, and as they return to more normal levels of leasing activity and making those decisions day to day, JLL, and, really, their peers, for that matter, will be at the table, earning commissions and helping those transactions. So we think there's a lot of runway to go from the leasing side. You're seeing investment sales activity really move higher. You're back above 2019 levels on that front, and so that's driving a lot of growth right now. And then the company has a very strong balance sheet that gives them the ability to go invest as well, and drive other parts of their business. So we think it's, broadly, a very good setup for a company like that, on the asset-light side, as opposed to being the office landlord.

JULIE HYMAN: Hey, Tony, one quick sort of side note on JLL, it's selling it's China real estate management unit, and it's interesting, anything that puts the words "China" and "property" or "real estate" in the same sentence right now, I think, is getting increased scrutiny. Is there any risk here that the deal doesn't happen, and then it's stuck with this real estate management unit at a time when, property-wise, things in China are, I don't know, a little bit challenged, one could say?

TONY PAOLONE: Yeah, it's possible, but, from our vantage point, thinking about JLL as a stock and as a company, that region, and that specific business line within the region, is very small, so, whether they sell it or not, it's, frankly, going to probably be a rounding error, from an earnings point of view, and it's also the reason why it, you know, potentially may be sold. So I think, when they looked back at that business, the customer base didn't necessarily line up with what they were trying to achieve globally, and it wasn't particularly sizable for them as a company. And so, you know, we'd like to see the sale go through, because it could be capital coming in that could be redeployed into something more strategic for the company, but if it doesn't happen, it's not big enough, from our vantage point, to move the needle from an investing point of view in JLL.

BRIAN SOZZI: Real good insight here. JPMorgan Senior Analyst and Co-Head of US Real Estate Stock Research Tony Paolone. Good to see you. Enjoy the rest of the week.