Annual REITs’ Review: REITs’ Convoluted Relationship With Interest Rates

Last year when the ten-year Treasury rate hit 350, many people in the market were convinced that the ten-year would stay above 3% for the foreseeable future. But then the Treasury rate dropped and net lease REIT Store Capital felt compelled to make a move. So it did a Treasury lock at 290 in order to issue debt. “We were happy with where ten-year was and we were happy issuing debt at that spread,” Chris Volk, president and CEO of the company, says. “So we locked in. Of course, as it turned out, we lost money on the lock.” Because with impeccable timing, the Treasury promptly dropped to 240 after STORE Capital’s lock.

It’s all good, though, Volk says. “We managed to borrow money a little cheaper than we would have” and that somewhat offset the loss. At any rate STORE Capital, as well as any other REIT more than one day old, knows it is more important to set and adhere to an overarching business and investment strategy than to make major decisions based on interest rates. A long period of stable interest rate policy-making still tends to be of shorter duration than, say, a REIT’s five-year strategic plan.

Indeed even now with the Federal Reserve signalling it is settling in for a dovish stretch of monetary policy, there are signs that this could change sooner rather than later. At the March 2019 meeting of the Federal Open Market Committee, several Federal Reserve policymakers left the door open for interest-rate increases later in the year if the economy improves—which most Fed officials do expect to see happen, especially with consumer spending, according to the minutes. “Some participants indicated that if the economy evolved as they currently expected, with economic growth above its longer-run trend rate, they would likely judge it appropriate to raise the target range for the federal funds rate modestly later this year,” according to the minutes.

REITs’ Relationship to Interest Rates

This is not to say that REITs—like most companies—don’t appreciate a low-interest rate environment. For starters, it means lower borrowing costs, says Mike DeMarco, CEO of Mack-Cali Realty Corp.

But REITs’ relationship with interest rates is also tightly intertwined with their stock market prices.

When interest rates rise, REIT shares usually take a hit because the market assumes they are too expensive to compete with other investments. When rates drop, REITs are in favor again. Industry advocates such as REIT association Nareit argue that rising rates—when they are a function of a strong economy—are good for REITs because that also means rising rents.

This is especially true of net lease REITs, Volk says. “People tend to treat us overly favorably when rates go down and overly punitive when rates go up.”

With rates increases temporarily on hiatus, the environment is very favorably for REITs right now, says Scott Robinson, director of the New York University’s Schack Institute of Real Estate’s REIT center and a clinical assistant professor who focuses on finance and investment. “Fundamentals are balanced, construction has been modest and the dovish actions on the monetary front is all good for REITs and real estate.”

The Longer Range

It is a good time, in short, to be executing on long-ranged plans. That is what Cedar Realty Trust is doing as it moves forward its mixed-use development projects, says President and CEO Bruce Schanzer.

A REIT focused on grocery-anchored retail, Cedar Realty has long been a fixture in the Boston-to-Washington, DC corridor. In recent years it has begun to work on enhancing the retail component of these retail properties by adding apartments and other uses.

“The idea is to take these retail assets and bring them into the 21st Century, making them better amenities for the communities,” says Schanzer. “We are moving to transform our portfolio to that of an owner of mixed-use assets that include apartments,” he says. Two examples he cites are South Quarter Crossing in Philadelphia and East River Park in Washington, DC. “These are great examples of Cedar executing on an ambitious urban mixed-use project that will become more of an asset for these communities,” he says.

Schanzer comes to the issue of interest rates from the perspective of a former REIT investment banker; he has spent time at Merrill Lynch, and then Goldman Sachs. His take is that the interest rate environment impacts REITs depending on why interest rates are behaving the way that they are.

“Sometimes rates are low because we are in low-growth environment or there is an effort to stimulate the economy or a secular shock, such as Brexit,” he explains. Generally speaking, he continues, a flat rate environment is good for REITs, assuming that rates aren’t low because of a market shock.

All that said, Cedar Realty’s strategy is a long-dated one that is not based around interest rates or what the capital markets are doing. Rather it focuses on demographics, macroeconomics and current trends that are driving growth: for example, it has watched Baby Boomers sell their suburban homes and move into urban cores. It has watched as other people have been priced out of the urban core for various reasons to move further out. Ergo, its strategy is focused on first ring outside of the urban core.

“We underwrite our projects very conservatively and there is no question than in a lower growth scenario we don’t want to underwrite too aggressively,” Schanzer says. “We want to make returns in a low growth environment.”

Low interest rates become a factor because it means lower borrowing costs, but that is largely the extent of the impact, Schanzer says. “We have five-year and seven-year plans and we expect we will be in a lot of different interest rate environments as we execute on these plans.”

Fewer Acquisitions?

One element of REITs’ strategic plan that may be put on hold, however, is a strong asset acquisition play. There is good reason for that, explains DeMarco of Mack-Cali Realty Corp.

“REITs’ acquisition pace has moderated because these companies still need to see a strong underlying growth in the economy, which has diminished a bit,” he says. The numbers bear this out: REITs’ pace of acquisitions has been markedly slow in 2019, a trend that is continuing from last year. In June 2018, Nareit reported that REITs’ net acquisitions had slowed from $50 billion in 2015, to $16.3 billion over the past four quarters.

To be sure one-off purchases are still happening; so are strategic portfolio buys. In April, to name one example of the former, Mack-Cali closed on the purchase of the 377-unit SoHo Lofts apartment tower in Jersey City, NJ, from AEW for $263.8 million. A more notable transaction for Mack-Cali, though, was its April sale of its 56-building, 3.1 million-square-foot office/flex portfolio in Westchester County, NY and Fairfield County, CT for $487.5 million. It was the last of its office/flex holdings, and the transaction allowed the REIT to fully focus on waterfront centric property and residential assets—an important strategic play.

Likewise with WashREIT, although it was on the buying end of a portfolio deal with strategic significance. In April, it entered into a definitive agreement to purchase a 2,113 unit multifamily portfolio for $461 million. The portfolio consists of seven suburban Class B apartment communities in Northern Virginia and Montgomery County, MD. The acquisition was in response to a trend that the REIT had been tracking in the Washington, DC area: namely, a growing affordability gap for housing not just at the lower end of the income spectrum but also among aging Millennials that are pulling down middle class salaries. The REIT has identified as its sweet spot a Millennial renter that is on the lower end of the income range and wants to live in the suburbs. This cohort is expected to grow as Millennials continue to age, thus increasing demand for the type of product that WashREIT just entered into a definitive agreement to acquire.

Perhaps the most profound illustration of how M&A are playing out in the REIT space this year has been the relative lack of the blockbuster public-to-private deals that the market saw in 2018. Here too, interest rates play a tangential role as lower rates tend to smooth out valuations. Robinson, the director of the New York University’s Schack Institute of Real Estate’s REIT center, for instance, does not expect to see many major private sector takedowns of REITs for that reason. “Generally, you need a definitive dislocation between NAV (net asset value) and sector private values,” he says. “With the more tepid interest rate outlook now I don’t expect to see much activity along these lines.”

An important addition to that statement, however, is that Robinson does expect to see public-to-public merger and acquisitions when the deals make strategic sense or are a tactical move.

Deals of this type have been happening on both small and large scales. In March, Cousins Properties and TIER REIT entered into a definitive merger agreement to combine in a stock-for-stock transaction. The combined company is to have an equity market capitalization of $5.9 billion, a total market capitalization of $7.8 billion and a portfolio of over 21 million square feet of offices located across the Sun Belt.

In April, Carter Validus Mission Critical REIT and Carter Validus Mission Critical REIT II entered into a definitive agreement to merge in a stock and cash transaction, creating an entity that will be valued at $3.2 billion.

Both of these deals are examples of REITs looking to expand for tactical reasons, such as wanting to bolster their exposure to different markets, or to add new concentrations or just increase scale to improve their access to liquidity, Robinson says.