Rate jitters hit REITs

Last month, the Bank of Canada cut interest rates by a quarter-point for the third time this year, bringing the overnight target rate down to 2 per cent. That’s the lowest it has been since April 2002. A year ago at this time the target rate stood at 3.25 per cent so we have seen a big retreat in just 12 months.

So what happened? On the day following the cut, the Canadian stock market plunged, partly because of worries about higher interest rates!

Incongruous as that may seem, the market isn’t stupid. In fact, we’ve probably seen the last of the interest rate cuts in both Canada and the U.S., perhaps for several years, unless something completely unexpected happens. The outlook now is for rates to remain stable for a few more months and then gradually begin to rise.

There are growing signs that the U.S. Federal Reserve Board, which had been expected to maintain its 1 per cent federal funds rate over the summer, may have to make a move sooner than expected. The U.S. Consumer Price Index for March showed that inflation jumped 0.5 per cent during the month and is now rising at an annualized rate of 5.1 per cent. The trailing 12-month rate is still only 1.7 per cen but the spike since the start of the year must be causing some worried frowns among the Fed governors.

An upward turn in interest rates generally has a negative effect on several types of securities. These include many income trusts, long-term bonds, and bank and utility stocks.

REITs were hit particularly hard by rate jitters in recent weeks. The S&P/TSX Capped REIT Index fell about 8 per cent in April. There could be more declines to come. Real estate investment trusts are especially vulnerable to rising interest rates for two reasons. First, as interest rates rise, the yields on REITs must rise as well to maintain the risk premium over bonds. Unless a REIT is able to significantly increase its pay-outs (which few, if any, can), higher yields can only be achieved through lower market prices.

The second factor is the heavy debt burden that REITs carry. Remember, these are real estate ventures. That means they finance their property acquisitions through mortgages. As mortgage rates rise, so do the costs of servicing the loans. That leads to lower profits and could ultimately affect distributions if rates move up significantly.

For example, RioCan REIT (TSX:REI), the country’s largest, was carrying mortgage loans totaling $1.72 billion at the end of 2003 with a weighted average interest rate of 7.15 per cent. Of those loans, $105 million come up for refinancing this year, $120 million next year, and about the same amount in 2006. Fortunately, most of RioCan’s loans are long term (more than half don’t mature until after 2008). But even half a percentage point average rate increase on those that mature in the next three years would add $1.7 million to RioCan’s carrying costs. That in a nutshell is why we have seen the whole REIT sector take such a big hit in recent weeks.

We are moving into a new phase in the economic cycle. For more than three years we have experienced a sluggish economy, falling interest rates, and, except for 2003, sagging stock markets. Now we are at a turning point. If the world unfolds as expected, look for the North American economy to gain momentum, inflation to once again become a concern for the central banks, interest rates to start rising this year, and the stock markets to slow down.

That said, no year so far in this century has been “normal”. The unexpected has become the new reality. So don’t rush to sell all your income trusts and bonds. Balance continues to be the key to long-term success. But if you have a big profit staring you in the face, you may want to take it.

This article originally appeared in the Internet Wealth Builder.