Real Estate Investment Trusts (REITs) are businesses that invest in property and then rent those properties out.
There are a number of different types of REITs such as shopping centres like Scentre Group (ASX: SCG), childcare properties like Arena REIT No 1 (ASX: ARF), self-storage providers like National Storage REIT (ASX: NSR) and farmland REIT Rural Funds Group (ASX: RFF).
Each sector of the REIT industry has its own merits but they are all in a similar boat when it comes to one risky factor.
All REITs in Australia have a certain amount of debt on their balance sheet because they utilise loans to purchase the properties in their portfolio. This has been very beneficial for them as interest rates came down in boosting property valuations and reducing expenses through the interest charged.
The S&P/ASX 200 A-REIT Index (ASX: XPJ) has soundly outperformed the S&P/ASX 200 Index (Index: ^AXJO) (ASX: XJO) over the last five years, but I don't think the environment will be anywhere near as good for REITs over the next five years.
The Federal Reserve in the USA has started raising its base lending rate from its historic low. A lot of our banks get funding which is directly or indirectly related to the American interest rate. We have already seen our big four banks pass on a number of out-of-cycle rises to property owners.
Banks will pass on increased interest rates for REITs too, including on debt that needs to be refinanced in the coming months and years.
All REITs could be affected by this, such as Scentre Group which has gearing of 33.3% and an effective interest rate of 4.5%, or National Storage which has gearing of 34.6% and an effective interest rate of 3.9%. An increase to the interest rate by 1% could increase the finance costs of Scentre Group and National Storage by 22% to 25% respectively.
The rising interest rate could also have a negative effect on the valuations on the properties too. This hurts the net tangible assets per security statistic, which could hurt the share price.
Foolish takeaway
I don't think investors should sell all their REIT shares, particularly as some still offer a very pleasing dividend yield. However, it will be difficult for most REITs to beat some of the other options on the market in the short to medium-term.
