Real estate investment trusts (REITs) and related ETFs are usually viewed as rate-sensitive instruments, and with good reason.
Much of that boils down to real estate being a capital-intensive endeavor. That means REITs often fund expansion and new projects by issuing debt. That’s tolerable when interest rates are low. But that’s obviously not the case today. And that’s why the S&P Real Estate Select Sector Index plunged 26.2% in 2022 when the Federal Reserve commenced interest rate tightening.
There’s no denying higher interest rates have caused some calamity in the commercial real estate realm. That’s because defaults have perked in some segments, including corporate offices and hotels. However, in what could be good news for funds such as the ALPS Active REIT ETF (REIT ), broader interest expense and leverage trends among real estate firms are actually encouraging.
Why It Matters for REIT
The aforementioned rate sensitivity of real estate equities could be weighing on the minds of investors. That could be keeping them skittish about ETFs such as REIT. It can be argued that REIT and some rivals may have been punished too severely by the Fed’s tightening cycle.
“From its peak during the global financial crisis, the average leverage ratio has dropped by nearly half to 33.8% in the first quarter of 2024. That’s a level akin to those used in lower risk private real estate investment strategies. The average interest expense ratio has followed a similar downward trend. It was a low 21.8% in the first quarter of 2024,” according to Nareit.
Said another way, real estate developers and landlords are devoting less capital to interest expenses. And leverage ratios are trending in the right direction. But real estate stocks might not be earning adequate credit for those trends.
REIT could also be relevant to advisors and investors considering revisiting the real estate sector over the near term because it’s actively managed. When it comes to real estate equities, active managers can more nimbly focus on value opportunities and low leverage names than basic indexes can. Likewise, active managers can avoid REITs that are default candidates. They can do so while potentially increasing allocations to subsectors with the most attractive long-term growth prospects.
“Long-term, well-structured balance sheets with low leverage ratios that predominantly use unsecured debt and fixed interest rates have served REITs well in the current interest rate environment. Today, REITs are facing less stress and enjoying greater operational flexibility than their counterparts with higher debt loads and costs,” added Nareit.
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