REITs in a Rising Rate Environment: What Every Canadian Investor Should Know

REITs can be moody when interest rates are high – here’s what you need to know before investing.

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Are you currently nursing unrealized losses in a Real Estate Investment Trust (REIT)? If so, you’re not alone. Both in 2022 and continuing into this year, the REIT sector has faced significant challenges, leaving many investors in a difficult position.

The primary culprit behind this downturn? Elevated interest rates. While the Bank of Canada (BoC) held rates steady at 5% during their December 6th meeting, the future remains uncertain.

The BoC’s decision to keep interest rates high has been primarily driven by the need to bring inflation back down to its long-term targets.

The prevailing sentiment suggests a ‘higher for longer’ interest rate scenario, which poses unique challenges and considerations for REIT investments.

As a Canadian investor, it’s crucial to understand the intricate relationship between REITs and rising interest rates. Here’s what you need to know about this dynamic, and I’ll also share my preferred ETF for REIT investing in Canada.

Rising rates & REIT fundamentals

REITs are particularly sensitive to interest rate changes due to their reliance on leverage. These trusts often use borrowed capital to finance property acquisitions and developments.

When interest rates rise, the cost of borrowing increases, leading to higher expenses for REITs and potentially lower profit margins. This change can directly affect their fundamentals – namely, their ability to generate income and sustain growth.

Additionally, higher interest rates can impact the valuation of properties owned by REITs. As borrowing costs rise, the demand for real estate may cool, potentially leading to a decrease in property values. This scenario can adversely affect the balance sheets of REITs, which are heavily invested in real estate assets.

Rising rates & REIT investor sentiment

From an investor sentiment perspective, rising interest rates can make REITs less attractive compared to less risky asset classes. With the Bank of Canada’s rates at 5%, cash and cash equivalents offer a relatively risk-free yield, making them more appealing to risk-averse investors.

In a higher interest rate environment, the risk-return trade-off shifts, and investors may opt for safer investments with guaranteed returns rather than riskier assets like REITs, which are exposed to market volatility and real estate sector risks.

What this means for you

The combined effect of these factors – increased borrowing costs impacting fundamentals and a shift in investor sentiment favoring lower-risk assets – can lead to a sell-off in REITs.

Investors, wary of the increased expenses and reduced profitability potential of REITs, along with the allure of safer, interest-bearing assets, might choose to divest from this sector.

This trend can result in an overall decline in REIT prices, reflecting the market’s response to the changing economic environment.

If you do want to go long on REITs right now in anticipation of a discount, consider a REIT ETF that holds a diversified portfolio of them. My personal pick here is CI Canadian REIT ETF (TSX:RIT).

As an actively managed ETF, RIT is fairly pricey with a 0.87% expense ratio, but has historically made up for it with great outperformance versus its passive market-cap weighted and equal-weighted index counterparts net of fees.

I personally like this ETF for my REIT exposure because it is able to hold up to 30% of its portfolio in foreign REITs, which at present is mostly in U.S.-listed REITs. This can help investors obtain exposure to other real estate markets when the Canadian one is facing headwinds.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Tony Dong has positions in CI Canadian REIT ETF. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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