Why I won’t buy REITs amid a rising interest rate environment

If investors that hold A-REITs (real estate investment trusts) believe they are exposed to the housing market, then they need to think again, as only 0.5% of the S&P/ASX 300 A-REIT (AUD) index is Residential Reits (See Figgure 1) including Mirvac Group (ASX: MRV) and Stockland Corporation Ltd (ASX: SGP).

Although, now it is positive not be exposed to housing via A-REITs with the softening residential housing markets.

Figure 1: S&P/ASX300 A-REIT sector breakdown

The yields of A-REITs have been atrractive with the sector yielding an average of 5.5% pa (UBS calculation), which is generally unfranked as A-REITS pay distributions rather than dividends (for tax purposes as distributions are paid out of tax free income).

There is a strong negative correlation between the A-REIT sector’s share price performance and changes in the long bond yield. Note that rising global rates have led to our long bond yields rising.

REITs are traditionally a defensive assest class, so rising rates have led some investors to rotate away into less defensive shares. But, the direct impact of rising interest rates on A-REITs’ profits is more gradual as many of the A-REITs have investments in commerical real estate with long term contracts in place, which are linked to inflation (so can be a hedge to rising rates). A-REITs with higher gearing will feel the pain more from rising rates.

The A-REIT sector suffered signficantly during the GFC, with major falls on the back of what could be called mismanagment due to over-gearing, investment in non-related business, unsustainably high payout ratios and paying distributions from borrowings.

In the aftermath the sector has cleaned up its act but watch for A-REITS returning to bad habits by increasing gearing levels close to 50%, while the average gearing is around 29%, and paying out distributions from debt rather than earnings.

Investors will see the greatest benefits from A-REITS with low gearing, but A-REITS also offer secure distributions and attract institutional investors wanting exposure to institutional grade real estate.

The sector is likely to do better if interest rates remain low, while further softening in bond yields will negatively impact prices.

The six things to watch are:

  1. Gearing levels: Average gearing of 29%, moving towards 50% is in dangerous territory.
  2. Discount to net tangible assests (NTA): the long term average discount is 6.7% (UBS forecast), so watch for wider discounts suggesting there could be a buy-back, a takeover target or buying opportunity (See The Fool)
  3. Distribution yield: A-REITs trade on an average 5.5% distribution yield (UBS).
  4. Softening retail sector: Growing online purchases and dangerous levels of consumer debt seen as a negative for A-REITS heavily exposed to retail.
  5. Rising long bond yields: Will cause a sell off in A-REITS, especially those with more debt.
  6. Payout ratio: 100% or more means that no funds are being retained for growth.

Figure 2 Top three A-REITS by market cap.

Forget REITS and try Our Top 3 ASX Blue Chips To Buy In 2018

For many, blue chip stocks mean stability, profitability and regular dividends, often fully franked..

But knowing which blue chips to buy, and when, can be fraught with danger.

The Motley Fool’s in-house analyst team has poured over thousands of hours worth of proprietary research to bring you the names of "The Motley Fool’s Top 3 Blue Chip Stocks for 2018."

Each one pays a fully franked dividend. Each one has not only grown its profits, but has also grown its dividend. One increased it by a whopping 33%, while another trades on a grossed up (fully franked) dividend yield of almost 7%.

The names of these Top 3 ASX Blue Chips are included in this specially prepared free report. But you will have to hurry. Depending on demand – and how quickly the share prices of these companies moves – we may be forced to remove this report.

Click here to claim your free report.

Motley Fool contributor Rosemary Steinfort has no position in any of the stocks mentioned. The Motley Fool Australia has recommended Scentre Group. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

The 5 mining stocks we’re recommending in 2019…

For decades, Australian mining companies have minted money for individual investors like you and me. But if you believe the pundits and talking heads on TV, those days are long gone. Finito! Behind us forever…

We say nothing could be further from the truth. To earn the really massive returns, you’ve got to fish where others aren’t fishing—and the mining sector could be primed for a resurgence. That’s why top Motley Fool analysts just revealed their exciting new research on 5 ASX miners they believe could help you profit in 2019 and beyond…


The best way we see to play the global zinc shortage… Our #1 favourite large-cap miner (hint: it’s not BHP)… one early-stage gold miner we think could hit the motherlode… Plus two more surprising companies you probably haven’t heard of yet!

For free access to our brand-new research, simply click here or the link below. But be warned, this research is available free for a limited time only, and we reserve the right to withdraw it at any time.

Click here for your FREE report!