This is the next part of my analyses of REITs. Refer to Part 1 here. The first part handles the components of a dividend yield, where I talked about that the risk-free rate pieces the bottom for a REIT’s dividend yield. In this post, I will concentrate on this component, as it is a long term driver of REIT produces as a sector. Brief history of interest levels. Broadly speaking, as REITs trade like rubbish/high produce bonds, changes in government connection produces generally drive dividend produces. While short term rates of interest were close to zero, longer-term interest rates remained higher somewhat.

This led the Federal Reserve to embark on a series of federal government relationship buying sprees. This entailed the central bank or investment company entering the federal government connection market, and purchasing bonds using what was essentially digital money created out of nothing. This is known as the Quantitative Easing (QE) program. The net result of several rounds of QE resulted in lower bond produces and much more profit the financial system.

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If you thought low relationship yields are already bad enough, other major economies of the developed world, specifically Japan and European countries took this unconventional financial plan to new heights, by pushing interest rates and government bond yields into negative territory. The goal of this radical monetary policy was to lower borrowing costs in order to stimulate financial activity, but the side-effect was inflation of asset prices globally (primary beneficiaries were stocks and real estate). In case you were wondering, a connection with a poor yield does not mean a poor coupon.

It just means that the bondholder will eventually obtain his principal upon bond maturity that is leaner than his preliminary purchase price, with the coupons collected insufficient to pay for that difference. How does this tie into REITs? Institutional traders drive global marketplaces. The gamut is run by them from hedge funds, family offices, banks, treasury tables of large corporations, to central banking institutions and sovereign prosperity funds. Each of them have varying levels of risk appetites and investment horizons, but appealing to us are what exactly are known as ‘Liability Driven Investors’ (LDIs).

LDIs are basically investors that produce investment decisions with the principal goal of reaching future liabilities. Consider your own personal plans (perhaps life, or even medical care insurance) from the perspective of your insurer. Your insurance firm must be able to generate sufficient comes back from its profile not just to meet a claim anytime between your present and years from now, but generate profits to satisfy its shareholders at the same time. As such, LDIs typically rely on stable but low volatility investments to meet its ongoing commitments. In the pre-crisis era, bonds constituted the bulk of an LDI’s portfolio.

However, zero/negative rates of interest and very low bond yields have made traditional LDI asset allocation very unsuitable for apparent reasons. This has led to LDIs allocating more property to stocks and shares in a bid to generate better returns, and REITs have been an all natural option to bonds due to their relatively steady dividend produces.

It is this relationship that has transformed REITs into a quasi-junk bond investment class. It is through this mechanism that we can see why REITs have a tendency to perform badly in intervals of rising relationship yields, despite the broader stock market faring well. Likewise, falling bond yields globally since past due 2018 has translated in an easy structured REIT rally, because REIT dividend yields are falling simply, tracking the underlying fall in connection yields.

So when do REITs generally perform well? The sweet place where most REITs outperform or perform as well as regular stocks and shares is within a ‘goldilocks-like’ situation of humble economic growth. With this weather of lukewarm growth and business sentiments, central banks tend to keep interest rates monetary and low conditions easy.

On the other hands, strong financial growth usually means higher interest rates, such as the US in 2017-18, which led to bond yields rising and eventually hurt REITs globally. So far I have only touched on the market aspect of dividend yields and bond yields/interest rates. Bond yields also affect a REIT’s fundamentals in conditions of its interest expense, since all REITs are leveraged. Rising rates of interest will lead to lower DPU, holding all else constant. Since REITs be capable of remove bank or investment company issue or loans bonds, rising rates of interest and bond yields will generally affect their interest expense. Also, interest levels feature heavily in the calculus of acquiring new assets.

The REIT manager will have to element in the prevailing cost of personal debt (interest cost) plus cost of equity, if the REIT has to raise fresh equity. Should the cost of debts and/or cost of equity be higher relative to the yield of the asset-that-is-to-be-acquired, the deal shall finish up to be DPU dilutive. Therefore, rates of interest can and do impact the viability of new assets.

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