Nertu
I think it's pretty hard to predict what the Fed will do to get an edge. There are thousands of analysts watching it and we all have access to the same information. So while I have my own opinion on if and when the Fed will cut rates, it's probably just as useful to know what the market as a whole thinks will happen.
Using futures prices, we can calculate the market-implied probability of a rate cut: As of July 9, 2024, the market sees a 70% chance of one 25 basis point rate cut in September from the current 525-550 range to 500-525.
Markets expect two 25 basis point rate cuts by December, with the next most likely being three or one rate cut.
This is a very neat bell curve of expectations centered around two rate cuts by the end of the year.
Of course, the consensus is not always right, but it is probably the best estimate available. I believe the consensus is also in line with fundamentals, as inflation has posted favorable readings in succession and employment is certainly showing signs of weakening. Thus, the market consensus is consistent with the Fed's dual mandate of maximum employment and maintaining price stability.
In recent public comments, Chairman Powell has grown increasingly concerned about employment imperatives and appears to recognize the significant risks of waiting too long to cut rates.
So while a rate cut is far from certain, both the market and fundamentals suggest it is likely.
So you need to understand what the investment impacts will be. I will leave the impact on the S&P to the general public and focus on my area of research: REITs.
How interest rate cuts affect REITs
Conventional wisdom dictates that REITs lose when interest rates rise and win when interest rates fall. Look no further than the inverse correlation between Vanguard Real Estate Index Fund ETF Shares (NYSEARCA:VNQ) and the 10-year Treasury yield (US10Y). For years now, REITs have fallen on most days that interest rates have risen.
As such, it is generally thought that falling interest rates are a tailwind for REIT stock prices, but we think it is better to understand this more deeply, so we would like to examine the mechanism by which interest rates affect REITs.
Positive impact of falling interest rates on REITs:
Cap rates fall (not parallel). Volume recovers. Cost of capital decreases, enabling acquisitions. Multiple expansion. Interest expense decreases. TINA recovers. M&A driven.
Falling interest rates will negatively impact REITs:
Construction becomes more feasible. Ownership becomes more viable (potentially reducing tenant demand).
Cap Rate
In theory, real estate should be priced at some spread over government bonds: if government bonds have a yield of X, then buying real estate should give you a yield of X plus some spread to compensate you for the risk.
So in theory, cap rates should move in tandem with Treasury yields. But while 10-year Treasury yields have risen by 200-300 basis points, cap rates have only risen by around 100-200 basis points, depending on the sector.
The reason cap rates have not moved in parallel is because of the growth component: rising interest rates accelerate long-term rental growth for real estate, so a fall in cap rates could be justified by higher growth rates.
We expect similar movements on the way down, but not perfectly parallel. Even more notable is that interest rates are unlikely to fall all the way again. Overall, I think cap rates will probably fall 50-75 basis points in the reduction cycle.
Cost of capital (debt) – low interest rates
The cost of capital should fall along with interest rates, through the obvious mechanism of mortgages and other debt becoming cheaper.
Cost of capital (equity) – multiple expansion
REIT multiples have fallen to nearly 18x in a low interest rate environment, but the median P/FFO is now at 12.7x.
That's how the entire market should work. The risk free rate should be a key factor in the denominator when valuing everything. It is consistent with financial theory for REITs to trade at cheap valuations in a high interest rate environment. The real phenomenon today is that the S&P and Nasdaq have somehow avoided the denominator effect of a rising risk free rate and are currently trading at extremely high multiples despite the high risk free rate.
Assuming financial theory applies in both directions, a decline in the risk-free rate should cause REIT multiples to rise again. I don't think we'll see a rise to 18x, but a return to a median REIT multiple of 15x seems pretty reasonable to me.
Trading Volume
Real estate transactions are at a standstill: sellers don't want to sell at high cap rates because they believe that if interest rates fall, so will cap rates, while buyers can't buy at low cap rates because their cost of capital is now high.
As a result, there is a significant difference in the prices that real estate buyers and sellers are asking, resulting in extremely low transaction volume.
Lower costs of both equity and debt will encourage more deals to be done again, once again creating opportunities for mutual benefit in real estate transactions.
TINA is back
TINA (No Alternative) is a term that refers to the shortage of income investments available in a low interest rate environment. Neither government nor corporate bonds were able to meet investors' income needs, pushing many investors who would normally stick to bonds down the risk curve and into stocks.
REITs have become a target for income investors, and as a result, REIT stock prices have reached all-time highs in 2021 amid a zero interest rate environment.
If interest rates fall, TINA will bounce back, but it may do so in a weaker form since interest rates are unlikely to return to zero.
The REIT multiple expansion mentioned above is a rational and fundamental response, whereas TINA is more of a constituent effect. In other words, REIT multiples should expand fundamentally because the denominator is falling, but the decline in high-yielding investments that drive investors into REITs has an irrational effect on market prices.
The constituency effect has driven REITs above their fair value in 2021. In the current environment, REITs are trading well below their fair value, so I see this as a catalyst to reach fair value instead.
Promoting M&A
Just as the deal market was in turmoil, M&A in the real estate industry remained light for similar cost of capital reasons.
As capital eases, we expect to see an increase in mergers between publicly traded REITs and private equity acquisitions of publicly traded REITs.
The downside
Each of the above mechanisms prioritizes either the REIT's fundamental value or the REIT's market price.
But lower interest rates also have negative effects.
Long-term property rental growth is linked to the relative cost of owning versus the cost of borrowing.
If the cost of ownership is too high, businesses and individuals will be willing to pay significantly higher rents to avoid the costs of ownership.
High interest rates in 2023 and 2024 have significantly inhibited construction activity, reducing competition for existing properties and resulting in the rapid rent growth that REITs have enjoyed due to rising interest rates.
As interest rates fall, construction will begin to pick up again, and as supply returns, rental growth will begin to slow to normal levels again.
Given the long time it takes to plan for construction activity, these effects will have a lag of one to four years, depending on property type, location, and size. Essentially, lower construction starts in 2023 and 2024 will benefit REIT FFO growth in 2025-2027.
If interest rates start to fall in 2024, the big rent increases from 2027 onwards will slowly taper off.
I believe this is the component of interest rates that is most widely misunderstood by the market.
The zero interest rate environment has been terrible for REITs, and unhealthy low interest rates in the wake of the pandemic are the main reason for the lackluster FFO/share growth in 2023 and 2024.
I view the recent sharp rise in interest rates as a kind of medicine for REITs: Falling rates were a bitter experience, but the underlying fundamentals have recovered.
The barrier to entry in real estate is the huge initial capital cost. When capital was free, the real estate industry lost its incumbent advantage. With the barrier to entry back in place, construction stopped and occupancy rates and rents began to rise for most property types.
The overall impact of interest rate cuts
I think a reduction would be quite beneficial to the REIT's market price by returning FFO multiples to more normal levels.
Essentially, interest rates are more neutral. REITs do best when the 10-year Treasury yield is between 2.5% and 6%. A few rate cuts are fine and probably beneficial as they help prevent the yield curve from inverting, but a return to a zero interest rate policy is undesirable.
REITs are best positioned to benefit from lower interest rates
While this could be a tailwind for REITs in general, there are two categories of REITs that should particularly benefit.
Discounted preferred stock. Moderate to high leverage and strong business.
Discount Preferred Stock
The idea here is basic: bonds are trading well below par value to make current yields relevant to a high interest rate environment. As interest rates fall, bonds will trade closer to par value, leading to capital appreciation along with dividends.
Leverage is useful if your business is doing well
Leverage has become a notorious word in REITs recently, as the magnitude of a REIT market price decline is directly correlated to the leverage of said REIT.
To be sure, leverage is bad when a business is struggling, but strong fundamental companies that just happen to be highly leveraged will disproportionately benefit from lower interest rates. Many of these companies sold stock out of fear of rising debt-servicing costs, but that may no longer be the case. Stable or even potentially lower debt costs would highlight the fundamental strength of the business.
Many of the REITs in this category trade at around 8-11x FFO, meaning there's plenty of room for multiples to expand as fears ease.
Predicting market reaction to falling interest rates
On July 11, 2024, a very low inflation report was released, further raising expectations of a near-term rate cut. The market responded as follows:
REITs were up 2.66%. Of course, this is just one data point, but I think it's consistent with how the market has looked at interest rates and REITs for a long time.
Conclusion
The above mechanisms can help you determine which REITs are best suited to your environment: If interest rates do indeed fall, REITs could see a market price tailwind for the first time in years.