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Ask Millionacres: Are REITs a Good Inflation Hedge?

[Updated: Mar 03, 2021 ] Jun 30, 2020 by Matt Frankel, CFP
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Q: Are REITs a good hedge against rising inflation and interest rates? If I'm anticipating rising interest rates and inflation in the future, should I put more money into REITs now? -- James H.

First of all, I wouldn't exactly call inflation a positive catalyst for REITs. It may seem like inflation would help -- after all, real estate prices (like the price of your home) tend to keep up with inflation. But when it comes to REITs, it just isn't the case.

For one thing, not all REITs have the same level of pricing power in an inflationary environment. Sure, hotel REITs can adjust their room rates to keep up with inflation and apartment REITs can adjust their rent annually, but with most other types of REITs, that isn't the case.

As an example, consider that most retail REITs have tenants sign long-term leases, many with initial terms of 15 years or more. These typically have annual rent increases (known as escalators) built in, and they're usually in the 1%-2% range. If inflation rises to say, 4%, a REIT in this situation would see rent rise far slower than the inflation rate.

Furthermore, even if a REIT has the power to adjust prices to keep up with inflation, demand needs to rise accordingly. Inflation without sufficient wage growth, for example, can produce declining demand.

So the short answer is that inflation affects some types of REITs more than others, but it is generally a negative factor.

More importantly than inflation itself, rising inflation is typically accompanied by rising interest rates, which is generally bad news for REITs. When rates rise, it gets more expensive for REITs to borrow money, and virtually all major REITs rely on the debt markets to fund growth. And second, when interest rates rise, dividend yields generally rise as well. The short explanation is that investors expect a certain risk premium over what they could get from Treasury securities, and when Treasury yields rise, so do REIT yields. Price and yield have an inverse relationship, so higher yields mean lower REIT stock prices. REIT prices tend to move in the opposite direction of Treasury yields.

Interest rates are currently at near-record lows. This would typically be great for REITs, but the effects of the COVID-19 pandemic have made the low-rate environment a moot point.

The bottom line is that REITs aren't a great hedge against rising inflation and interest rates, and (in the absence of a global pandemic) I would expect rising inflation and rates to have a generally negative effect on REIT prices.

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