Listed real estate: an unexpected buttress against rising rates?

After a strong year for listed property, many are wondering whether the sector can continue to grow with a possible rise in interest rates on the horizon. We argue that listed property can not only grow, but also be a useful diversifier for investors seeking a way to gain global exposure to a liquid asset class.

18 May 2015

After a strong year for listed real estate securities, many investors are wondering whether the sector can continue to grow in an economic environment which may see rising interest rates. We think it can. Indeed we think listed property can be a useful diversifier for investors looking for a way to gain exposure to real estate, traditionally seen as an illiquid asset class. Typically, real estate investors tend to allocate only to their domestic market and predominantly to physical assets. In fact, real estate securities give exposure to companies with high quality management teams around the world in a variety of subsectors, thereby reducing the risk to investors who do not have the knowledge to invest directly.

In 2014 the listed real estate sector (which includes REITs) delivered returns of over 15%, with the US alone rising by over 30%1 . We believe that the continuation of a low growth environment will be supportive of the real estate sector as long as investors are selective in their approach. With bond yields at historically low levels and investors searching for income, real estate offers both income and the potential for capital growth.

Will resurgent rates demolish returns?

There is a strong – and we believe misguided – belief that, as interest rates rise, the listed real estate sector will underperform. If increasing rates drag bond yields up, the expectation is that investors will move back into bonds from other higher yielding asset classes.

Figure 1: Interest rates and real estate can move up together

 Source: FactSet, Thomson Reuters Datastream, Schroders as at 31 January 2015.

It is certainly true that the announcement of increases in interest rates, or indeed other measures designed to limit economic growth, can cause short-term volatility in the listed property sector. This happened in 2013 when the US Federal Reserve (Fed) announced that
it would taper its bond buying programme. However, it is worth looking a bit further back in history to gain some clues as to how the market reacts over a slightly longer period. The period 2004 to 2006 saw a total of 17 US Fed rate increases against the background of an improving economic climate. Despite that, over these years the US listed real estate market still delivered returns of almost 80% (Figure 1). This does not suggest a negative relationship between tighter money and the real estate market.

There is no question that many investors are constantly on the lookout for more promising income propositions. However, with US 10-year Treasuries currently yielding less than 2% and 30-year Treasuries less than 2.6%2, it will take a significant correction to make them attractive
compared with higher yielding companies in the property sector. For instance, a number of Australian property companies are currently paying dividends of 5% or more, as are a number
of Singapore REITs3. Even in the stronger markets, such as the US West Coast and London,
bond yields will have to rise by a notable margin to be a threat.

This suggests that those markets offering both strong fundamentals and higher yields are more protected from the impact of rate rises, at least in the short to medium term. Further out, the likelihood is that any tightening announcement by the Fed this year will be as a result of an improving economy. Even then, such a decision will not be taken lightly and any increases will probably be in small steps, as a sharp rise could imperil the recovery.

1 FactSet, FTSE EPRA/NAREIT Developed, FTSE EPRA/NAREIT USA, in US dollar terms, gross, unhedged.
2 FactSet, as at 24 March 2015.

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