Why REITs aren't getting killed by rising interest rates this time around

The stocks of real estate investment trusts, or REITs, have long been considered a low interest rate play. That's because they are high-dividend stocks, and real estate values generally rise when rates fall. But some experts are making the case that real estate fundamentals today are outweighing even rising rates.

Correlations between REIT returns and changes in 10-year Treasury yields have repeatedly shifted over time, according to a new report from Cohen & Steers, which notes that the level or direction of rates alone has not been a reliable predictor of REIT performance.

Higher interest rates definitely hurt the commercial real estate sector from 2022 through 2024, as higher costs for borrowing lowered the value of assets. There was also a lot of new supply in several sectors, which caused rents and cash flow growth to slow down. Higher rates made it difficult for new development, but that is what is helping the sector in the current rising rate environment.

"Certainly 100 basis points in the last year on the 10-year [Treasury] is an impingement to the cost of debt and does also mean every other asset class now has to compete with higher yields," said Seth Laughlin, head of real estate strategy and research at Cohen & Steers.

"So you need to get a better yield from your alternatives, and real estate is definitely in that category. But at the same time, what we've seen is acceleration in earnings up to 9% this year. It'll be something similar next year. Call it 8% earnings growth," he added.

As new supply peaks, cash flow growth is improving and valuations are attractive relative to equities, according to Laughlin.

In fact, REIT to interest rate correlations are now at their lowest level in about four years, according to David Auerbach, chief investment officer, Hoya Capital Real Estate. He notes that fundamentals are much healthier than the headlines suggest, and 58 of 98 REITs providing full-year guidance raised their outlook.

"Excluding Data Centers, REIT development pipelines are roughly 40% below their 2022 peak and 2019 levels; Data Centers remain the exception at seven-times 2019 levels," Auerbach wrote in a report titled "The Rate Shock That Didn't Break REITs."

"Solid fundamentals are increasingly doing the heavy lifting, with healthy property-level cash flows, improving earnings visibility, strong dividend coverage, and better balance sheets helping REITs absorb the rate shock," he added.

REIT returns year-to-date are up over 6% according to the FTSE NAREIT All REIT Index. Specific sectors, however, are seeing outsized returns. Hotel and lodging, data centers and senior housing lead with double-digit returns.

Multifamily apartment REITs are still in negative territory, as the sector continues to work through a period of oversupply and weaker rents. Demand, however, for multifamily will grow along with interest rates, simply because fewer people will be able to afford to buy a home.

Other sectors like industrial, regional malls, and even office are seeing positive returns, despite higher interest rates.

"The truth is, under the hood, the economy is really healthy, and I think about REITs as sort of the landlord to the broader economy," said Laughlin.