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How Will Killam Apartment REIT Fare in a Higher Interest Rate Environment?

One of the interesting fundamental economic realities of the real estate investment trust (REIT) sector is the sensitivity of these securities to interest rates. As interest rates rise, either through rising government bond yields or an increase in the overnight lending rate set by the Bank of Canada, the performance of REITs such as Killam Apartment REIT  (TSX:KMP.UN) is generally perceived to be inversely related to interest rate moves; these securities typically benefit from lower rates and are punished by increasing interest rates.

The logic behind the way REITs interact with interest rates has to do partly with the fact that the REIT sector (along with the utilities sector and other similar high-yield areas) acts as a sort of bond proxy due to the relative safety of the security as well as the fact that the higher yields associated with these equities align REIT trust units more with bonds than traditional equities. As rates rise, it may make sense for investors to switch from a REIT that is yielding 4-5% to a bond that has just become cheaper and yields 4-5%.

The flip side of this argument, however, is that interest rate rises typically coincide with positive economic growth, meaning rental rates should increase and vacancy rates should decrease alongside rising interest rates, potentially producing a net benefit for the REIT in question. Given the nature of the real estate Killam is primarily associated with (residential apartments), in theory, if Killam is able to increase its rents at a faster rate than its mortgage rates (cost of borrowing) increases, the company should net positive.

In the company’s most recent annual report, it was noted that the weighted average years to debt maturity for the company’s portfolio stands at 4.3 years, meaning as long as Killam is able to raise rents faster than its average cost increases (which it appears able to do, given the strengthening of many of the residential markets Killam operates in), the REIT will be able to increase profitability in a rising interest rate environment.

Bottom line

Killam’s property mix, geographical areas of focus, diversification, and growth profile make this REIT my top choice for outperformance in 2017 and beyond. This is one company which will benefit from an improving Canadian economy, providing a unique growth profile amid a sector which is generally viewed to be defensive relative to most sectors.

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Fool contributor Chris MacDonald has no position in any stocks mentioned.

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