As we have discussed many times, much of the “conventional wisdom” on investing is simply wrong. For our purposes, we can define conventional wisdom as those ideas that become so commonly accepted that they go unquestioned. Today we’ll look at the idea that rising interest rates would doom returns to real estate investments, specifically the returns to real estate investment trusts (REITs).
This assumption, that returns from REITs will indeed tank if interest rates rise, is one I have been hearing a lot about lately as people speculate on the future actions of the Federal Reserve and projections for short- and long-term rates. This speculation seems to have reached even higher pitch (it that’s possible) ahead of the Dec. 16 meeting in which the Fed is expected to decide to raise interest rates.
As regular readers of my books and blog posts know, my writing isn’t based on my personal opinions, or anyone else’s for that matter. Instead, it is built upon findings from academic research, data and the historical evidence. However, before we dive into the data on interest rates and REIT returns, there’s an important point we have to cover, and that’s the difference between information and value-relevant information.
Information Vs. Value-Relevant Information
If you have information you think should impact the market—unless it happens to be inside information, on which it’s illegal to trade—that information is already embedded in the market’s prices. Thus, if the market expects interest rates to climb, the impact from rising interest rates is already reflected not only in the current yield curve, but also in the prices of REITs. It’s already too late to act on such information, because while it may be important information to have, it’s not “value-relevant” information.
To see evidence of the market’s expectation regarding rising interest rates, just examine the current yield curve. It’s about as steep as the historical average, with the difference between one-month bill rates and 10-year Treasurys now at about 2.3%.
With this understanding about the difference between information and value-relevant information, we can now turn to the evidence on the relationship between interest rates and REIT returns.
The Relationship Between REIT Returns And Interest Rates
To determine whether the conventional wisdom on the relationship between REIT returns and interest rates is correct, we can check the historical correlation of the returns between the Dow Jones U.S. Select REIT Index and five-year Treasury bonds.
For the period January 1978 to October 2015, the monthly correlation of returns was actually a positive 0.076. If we look at quarterly correlations, for the period January 1978 through September 2015, the correlation was 0.089. The semiannual correlation for the period January 1978 through June 2015 was even lower, at 0.023. And the annual correlation from January 1978 through December 2014 was lower still, at just 0.019. With correlations of close to zero, there’s really no basis for the belief in the conventional wisdom that rising rates are bad for REITs.
For another example of how the conventional wisdom associating rising interest rates with poor returns from REITs can be wrong, let’s look at some additional historical data. Specifically, let’s examine returns to the Dow Jones U.S. Select REIT Index during the last period of rising interest rates. The Federal Funds (FF) rate bottomed out on June 25, 2003, at 1%. Over the next several years, the Fed kept raising the FF rate until it peaked at 5.25% on June 29, 2006. On June 25, 2003, the five-year Treasury note was yielding 2.3%. On June 29, 2006, the yield had risen 2.9 percentage points to 5.2%.
How did REITs perform during this period of sharply rising rates? From July 2003 through June 2006, the Dow Jones U.S. Select REIT Index returned 27.68% per annum, providing a total return of 108.15%. During the same period, the S&P 500 Index returned 11.22% per annum, providing a total return of 37.57%.
Consider The Source
If rising rates are supposed to be bad for REITs (and for stocks in general), why did they produce such great returns? The reason is that the impact of rising rates on REIT returns depends on the sources of those rising rates. If rising rates reflect strong economic growth, then the expected returns to REIT investments might also be good.
This could be a reflection of stronger demand, as well as the likelihood of a falling risk premium, which causes valuations—for example, price-to-earnings ratios—to rise.
On the other hand, if interest rates are rising because inflation is growing faster than expected, the markets could become concerned that, in order to combat inflation, the Fed could begin tightening monetary policy. That would likely put a damper on economic growth, and probably cause a rise in the risk premium, which causes valuations to fall.
So we see that there are some periods where rising interest rates are more likely to be good for REITs, and some periods where rising rates are more likely to have a negative impact. That explains why the correlations have been close to zero over the long term.
The takeaway here is that, once again, we see that just because something falls under the conventional wisdom doesn’t make it correct. Hopefully, the lesson learned is to not simply accept the conventional wisdom as fact, but to question it and ask for the evidence supporting it.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.