On December 16, 2015, the US Federal Reserve raised the target range for the Federal Funds rate for the first time since 2006, and Janet Yellen, Chairman of the Federal Reserve Board, has indicated that more increases are likely. This movement by the Fed had long been expected, and much has been written about how higher US interest rates may impact markets and asset classes, globally as well as domestically. Some analysts have attempted to forecast what will happen if rates rise, while others have reported what happened in the past during rising rate periods. Here we take the latter approach, and report on what happened to the US listed real estate market (as represented by the FTSE EPRA/NAREIT and FTSE NAREIT indexes) during the most recent three periods of increases in the Fed Funds rate, giving special attention to the performance of different real estate sub-sectors. Vulnerability of listed real estate to rising interest rates is of particular interest, primarily due to their large dividends (payout ratios), use of leverage, and the rate sensitivity of their underlying property values.
We first establish a context for evaluating US real estate sector performance during periods of rising rates by reporting performance over the most recent calendar year—2015—as well as longer term outcomes over our entire sample period (January 1994 through December 2015). We then turn our attention to past periods of rising Fed Funds rates. In all cases, we look at broad measures of the US real estate market—based on FTSE EPRA/NAREIT and FTSE NAREIT Indexes—relative to the broad US equity market as measured by the Russell 3000® Index. This perspective offers information not only about how real estate stocks have fared relative to the broad equity market, but also about how major real estate sectors, i.e., developers and mortgage REITS, fared relative to equity REITS. We then drill down into US Equity REIT Sub-sectors for a more granular analysis.
Generally, we find:
Across broad FTSE EPRA/NAREIT and FTSE NAREIT Real Estate Indexes compared to the Russell 3000:
- Mortgage REITS have been challenged in all periods examined; the performance characteristics of mortgage REITS were significantly different from other REIT sectors over our sample periods. These results support the 2016 GICS separation of mortgage REITs from other equity REITS: equity REIT stocks will be moved into their own sector while mortgage REITS will remain in the GICS Financial sector classification.
- Over the entire sample period, non-REIT real estate stocks (e.g., developers) contributed positively to performance, but detracted in calendar year 2015; non-mortgage real estate stocks outperformed the broad equity market represented by Russell 3000 but posted equal risk-adjusted performance measures (Sharpe Ratios).
- The performance outcomes of equity REITS and non-REIT real estate stocks are mixed across past periods of rising Federal Funds rates, while Mortgage REITS consistently underperformed in each of these periods.
Among US Equity REIT Sub-sectors:
- Only the two business-related sub-sectors—Office and Industrials— had consistently positive excess returns over the broad FTSE NAREIT US Equity REIT Index over the three past periods of rising Federal Funds rates. Key retail/consumer driven sub-sectors such as the combined Retail Sector, Shopping Centers, Free Standing as well as the Manufactured Housing subsector underperformed in all three periods. Results for other sub-sectors were mixed.
- During 2015 and over the entire sample period, Self-Storage outperformed and Lodging/Resorts underperformed all other sub-sectors, whether measured by total returns or by Sharpe Ratios. Economic as well as demographic trends help explain these outcomes.
Sectors and Sub-sectors of the US Listed Real Estate Market
US Real Estate Broad Component Sectors: Public real estate stocks in the US are dominated by Equity REITS, and it is this part of the market we track here with the FTSE NAREIT US Equity REIT Index (FNUSERI). A broader measure of real-estate stocks, which includes development companies and other non-REIT real estate stocks, is provided by the FTSE EPRA/NAREIT US Index (FENUSI). Another important category is mortgage REITS, here represented by the FTSE NAREIT US Mortgage REIT Index. US Equity REIT Sub-sectors: the US Equity REIT market is divided by FTSE NAREIT into a number of sub-sectors. These sub-sector categories have varied over time as the types of Equity REITs listed in the US have evolved; in Table 1 we report the index weight and constituent count of key sub-sectors of the US Equity REIT Market as of year-end 2015.
These US Equity REIT key sub-sectors fall broadly into four general categories: those more driven by business or commercial enterprise such as Office and Industrial; retail-related sub-sectors (Shopping Centers, Regional Malls, and Free Standing); residential sectors (Apartments and Manufactured Housing); and a catch-all other category. The three largest sectors by index weight are Apartments, Office and Health Care; the three smallest by that measure are Free-Standing, Diversified and Lodging/Resorts. By constituent count, the three largest are Office and Shopping Centers, with Health Care and Lodging/Resorts tying for third. The three smallest sub-sectors based on constituent count are Manufactured Homes, Self-Storage and Free-Standing.
We caution that the performance of REIT sub-sectors can be driven by idiosyncratic—company specific—factors, as the constituent count of many of the sub-sectors is quite small. Other factors such as company and/or subsector differences in the use of leverage can impact performance differentials. Sector specific issues can be important, among them the average length of leases of the underlying properties, with Lodging/Resorts having the shortest leases (one-day on average) and the business-related sectors normally characterized by having the longest lease periods. The effect of idiosyncratic elements on return can be time-varying, as can the systematic (sector and market-based) drivers of returns.