Worried About REITs

REIT prices have already taken a hit. Are there more shocks to come?

Q – In an earlier article you warned that when interest rates started their rise, the interest sensitive sectors such as the REITs and utilities, in particular, would be adversely impacted.

I certainly did not imagine that the 10-year bond rate going from 1.6% to 2.2% would have such an immediate impact on those sectors. Anyway, I have held several REITS representing about 11% of our portfolio for about four years each but have added to positions during that time for income reasons (we are over age 70 but I enjoy managing our portfolio with some success).

If the REIT sector fell another 10% from the present levels, the REIT portion of our portfolio would still show a profit but I am more concerned about the probable negative impact on AFFOs (adjusted funds from operations) leading to distribution cuts as payout percentages increase. Moreover, am I correct in assuming that changes in the retail business models due to greater competition, over expansion, and lower pricing power are likely to lead to much lower growth for companies focused mainly in that sector, such as Riocan? Will changing business dynamics such as mergers and greater acceptance of working at home due to the support of business related software lead to less need for office space, not to mention Encana’s cost cuts that could impact the “Bow” in Calgary (Dundee, HR REIT)?

If you were in this position, what would you do? – Fraser E.

A – Rate increases are bad news for REITs for two reasons. First, it increases the cost of financing. Second, it narrows the yield gap between higher-risk REITs and lower-risk bonds, resulting in a price correction in the REITs to enhance yields.

However, interest rate increases go hand-in-hand with an improving economy. Economic growth should be beneficial to the cash flow of most REITs as it would result in lower vacancy rates and enhanced pricing power.

The risk of distribution cuts with REITs, or any other security, is a fact of life. I have no reason to expect distribution cuts in any major REITs in the near future but there are no guarantees.

As for what I would do, let’s just say I have not sold any of my REITs and have no plans to do so right now. – G.P.

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