Could rising interest rates hurt real estate investment trusts (REITs)?

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One way to get exposure to the property market without buying directly is to purchase shares in real estate investment trusts (REITs). Doing so could allow me to get into property even when investing less money than would be required for a deposit on most buy-to-let properties these days. The London stock market is home to dozens of REITs, including such well-known giants as British Land, Land Securities, and Shaftesbury. There are also REITS focussed on specific property types, like health-focussed Assura and the Supermarket Income REIT.

But as interest rates are set to rise, what does that mean for REITs? Does it hurt the investment case for a REIT like Safestore, which I currently hold in my portfolio?

Interest rate impact on REITs

There is no single correct answer to the question. That is because a REIT is simply a corporate structure, designed to eliminate some of the tax liabilities that could arise if a company owned property in another way.

So the impact of an interest rate rise will not affect different REITs in the same way. Instead, it will depend on the sorts of properties in a portfolio and how they are financed. If most of those properties are owned outright, rising rates would typically have less immediate impact on the bottom line than if they had a mortgage on them. But the cost of expanding the asset base may grow with higher interest rates.

Economic risks

However, rising interest rates can affect REITs in more ways than just pushing up the interest bill on their mortgages. When interest rates go up, consumers often have less spare money to spend, so may tighten their belts. In the early 1990s when interest rates got as high as 17%, there was a serious recession. Often when inflation is high, like now, policy makers choose to push up interest rates to combat it. One side effect can be an economic downturn.

A declining economy and weak consumer spending can be bad news for REITs. For example, British Land owns estates like London’s Broadgate and Paddington Central. I think they may find it harder to push through rent increases with retail and entertainment tenants if client revenues are falling significantly due to lower consumer spending.

Each REIT is different

I would look into certain details if I was buying shares in a REIT beyond just how attractive the business model looks today. For example, I would want to understand what its future interest liabilities are. The investment trust’s annual report should give details on how much interest payments cost in a year. I would read the accounts carefully to see whether that cost is expected to change dramatically.

I would also look to see what percentage of a company’s estate might be liable to a downturn in consumer spending. Some REITs may be much less hurt than others because of the nature of their tenants, or a reliance on very long leases.

A rising interest rate may hurt some REITs. But the exact impact will depend on the specific REIT concerned. At the moment, I am not keen to invest more money in property companies. I see growing risks in the sector if interest rates get very high. So I prefer to focus instead on opportunities elsewhere.