- Cost of funding
REITS has to distribute 90% of their income to the Unitholders. This means that it relies very much on debts for growth. Increase in interest rate will increase the cost of borrowing which eats into the income to be distributed.
2. Losing attractiveness as an alternative investment
In an high interest rate environment, there are safer alternative investments such as buying Treasury bills (Yield was at a 30-year high of 4.4% in December 2022) and placing deposits in bank. Hence, investors likely will turn to these investments that offers a lower risk.
3. Valuation of properties may drop
A high interest rate may lead to an increase in the capitalisation rate. According to the webpage dated 1st Feb 2024 from jpmorgan.com, the Fed’s interest rate hikes increased financing costs, limiting transaction volume and making it difficult to assess capitalisation rates. As a result, capitalisation rates have increased in the United States of America.
The formula to assess the value of property:
Value of property = Net property Income/ Capitalisation rate
When valuation of properties drop, the gearing ratio will increase which cause some of highly leveraged REITs to breach the gearing limit. Thus, financial institutions such as banks will be reluctant to extend loans to such REITS. This may force them to sell off assets at a loss or turn to investors to raise liquidity both of which are detrimental to investors.
Actions I wish I have taken along with Federal Reserve continually raising the interest rate
I wish I have sold some of the REITS at a higher price and perhaps buy it back when it corrected to an attractive pricing. These would have reduce the capital loss on my investments in REITS. However, timing the market is undeniably hard to execute.
Buy and hold has proven to be harmful to the portfolio. The upward trajectory for the interest rates undertaken by Fed has shown that the REITS took quite long to recover to their earlier pricing. A number of REITS has still not fully recovered to their prices in 2022.