How should we approach REITs as investments for income now?

All good things come to an end and although it is debatable whether the many rounds of quantitative easing (QE) by The Federal Reserve have been good for us, they are definitely coming to an end as the Fed cut their bond buying program to US$15 billion a month and indicated that QE will end in October. That's next month. Money supply will stop growing and interest rates could rise 6 months later.

Of course, for quite a while now, this is something that I have been talking about too and how I have been taking action to have a portfolio of investments that is going to be less easily affected by rising interest rates. How is this being achieved? Simply, it latches upon the idea that companies which have less debt will have a relatively lighter debt burden when interest rates rise, which they will.

Having said this, I am not saying that companies which have more debt will not do well when interest rates rise. Heavily leveraged companies which are growing their earnings rapidly could still overcome their higher cost of debt and deliver good results. These are probably some high growth companies.

However, as I am investing mostly for income and maybe a little bit of growth, I would like to have more predictability and I like companies with less debt which have shown themselves to be consistent payers of meaningful dividends. I like them even more now that interest rates are set to be higher in the near future.

Now, what about REITs?

REITs have conventionally been looked upon as an asset class that is somewhere in between stocks and bonds. The regular income distributions make them bond-like but when we hold REITs, we are investors and not lenders. When we hold bonds, we are actually lenders of money. This is, of course, an interesting bit of trivia for most people and what they are probably more interested in knowing is how rising interest rates would affect their investments.

Well, if interest rates should rise, as investors in REITs, we want to think of the following:

1. Cost of debt.
2. Distributable income.
3. Unit price.

Quite simply, if interest rates go up, the cost of debt goes up. More income will have to go to servicing debt. When this happens, the amount of income available for distribution to unit holders will reduce, everything else remaining equal. If distribution per unit (DPU) should reduce, then, unit price would fall accordingly as Mr. Market demands a distribution yield that makes sense to him.

So, does this mean that as interest rates rise, REITs become pariahs and we should avoid them at all costs? I am inclined to believe that if we are income investors, REITs remain relevant assets to own. However, we will have to pay more attention to the issue of debt. Specifically, we want to be mindful of the following:

1. Percentage of debt with fixed interest rates.
2. Debt maturity profile.
3. Average cost of debt.

In an environment of rising interest rates, home owners who have loans with fixed interest rates will worry less about the possibility of a higher cost of debt. For REITs, similarly, if a bigger percentage of their debt are of the fixed interest rate type, then, they have less to worry.

Eventually, all REITs will have to refinance but those which have most of their debt due for refinancing in the next 12 to 18 months will see their cost of debt increasing ahead of the pack. Of course, this will put downward pressure on their available income for distribution, all else remaining equal.

Finally, REITs with very low average cost of debt now would probably see a big percentage jump in their cost of debt when they refinance eventually. So, investors in such REITs must be mindful of this as the REITs' interest cover ratio (i.e. the ability of a REIT to pay interest on its debt) could take a relatively big hit.

Basically, a higher interest rate will result in weaker cash flow and balance sheet, all else remaining equal.

However, remember that REITs are not bonds. REITs could improve the amount of income available for distribution by getting cheaper loans which are less likely in future but they also have the ability to improve income by raising asking rents.

The question is whether the health of the economy and the sector which the REITs are found in will support higher rental rates or not although it is believed that in an inflationary environment (which is why interest rates should increase), asking rents should rise too.

So, there you have it. How should we approach REITs as investments for income in an environment of rising interest rates? We should be thinking about debt.

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