Here's What REIT Investors Need to Know About Inflation and Interest Rates

Dividend stocks can be particularly sensitive to interest rate fluctuations and inflationary environments, and real estate investment trusts, or REITs, are no exception. In this Motley Fool Live video clip, recorded on Aug. 17, Millionacres real estate analyst Matt Frankel, CFP, and editor Deidre Woollard discuss what investors should keep in mind as inflation remains at multi-decade highs. 

Deidre Woollard: If interest rates go up, will REITs go down in price? What is the long-term growth potential? It really depends on the REIT to some extent, I think.

Matthew Frankel: For the interest rates, the answer is yes. If the interest rates go up in the short term, REITs will generally go down in price in a normal environment. Now, that's only one dynamic that influences the prices of REITs. You're going to see other trends. From last March till today, Ryman (RHP -0.86%) is up 400%. That move wasn't caused by interest rates, it was caused by changes in the dynamics of the business. All things being equal in normal boring times, in 2018, 2019 when the Fed was raising rates and things like that, this was one of the big reasons you saw REITs underperform the market. It was because, without getting too deep in the weeds on how interest rates affect stocks, generally speaking, yield and stock prices move in opposite directions. When the yield you can get from risk-free investments, like Treasuries, goes up, which is what this is talking about, interest rates going up, the yields investors expect for the riskier investments, like dividend stocks like REITs, goes up. Investors expect higher yields from REITs, that puts pressure on reprices. So all other factors being equal, spiking interest rates are generally a negative catalyst for REITs. But I'll add something to that. If spiking interest rates are caused by really strong economic activity and REIT earnings are going through the roof, it can really counteract that. So the short answer is yes, but it's only one piece of the puzzle. It's like I said, in boring markets, you'll see this effect more pronounced. But right now there's a whole lot going on. The Delta surge, the reopening, the start of college, group events coming back. There's so many different dynamics in play right now that interest rates are really a secondary concern unless they really spike.

Woollard: Yeah. It doesn't seem likely that they'll really spike. A related question I wanted to talk to you about is inflation because I think one of the things that people ask, are REITs a hedge against inflation? Certainly, there's the idea that there's flexibility within a REIT, depending on the REIT of course, being able to raise rents or things like that to counteract the impact of inflation. Of course, you can't use that on something like an office REIT where you've got a five or seven-year lease. But what do you think about the impact of inflation on REITs?

Frankel: Well, inflation and interest rates generally move in the same direction, first of all. Going back to that previous question, higher inflation usually leads to higher interest rates which can put negative pressure on REITs. However, REITs have different degrees of pricing power. You mentioned office REITS, that leaves REITs like Realty Income (O 0.24%), for example, are another example that have very low pricing power. Tenants might sign 15-year leases with one percent annual increases built-in, something to that effect. If inflation is devaluing the dollar by 5% a year and your average rent is going up by 1% a year, that's not very good for your business. On the other hand, when you think of a hotel REIT that has the ability to adjust its rent on a daily basis, that's pricing power, especially if inflation is going up and the economy is still strong, like consumer demand is still high, things like that. That's a really good combination to have, is daily pricing power and rising prices. If the average hotel rate goes up by 10 percent, hotels have the ability to do that like that with a click of their mouse, it could be really good for their short-term gains. On the other hand, you will see a lot of the stable REITs come under pressure because they don't have that immediate ability to adjust their pricing. Especially one like a Realty Income or a Store Capital (STOR), which is another favorite of ours, that's 99.7% occupied, so they don't even really have the ability to lease vacant properties at higher rates and take advantage of the inflation. The trade-off they have much more stable cash flow, no matter what the economy is doing. So if there's no inflation or there's a recession or something like that, they're still going to make their money. But it depends on how short-term their lease structure is and how much pricing power their particular business has.