REITs and interest rate increases

Real estate has been one of the key alternative investments for investors. It provides positive cash flows and should also do well if there is an increase in inflation because the underlying real asset should increase in value and rents should also increase. Higher prices can be passed through higher as higher leases.

However, for many investors a more relevant question is what will happen to REITs if interest rates increase? Will REITs still be a good investment? The answer is mixed. During the biggest moves in interest rates over the last 20 years, we find that it will underperform the SP 500. There will be a drag of 450 bps from stocks during periods when the average increase in yields have been up around 150. Some of the yield increases have been caused by increases in real rates and others times from higher expected inflation. The reasons have been mixed but there results have been the same. There have been rising rate periods in '94, '99, and '13 when REIT returns have been negative.

It is unclear that REITs are an effective investment during a rising interest rate environment. Asset allocation should not be about what has worked in the past but what will be effective during future scenarios. If you expect higher rates, REITs as an alternative investment may be disappointing.