On March 15, 2017, the Fed raised its benchmark federal funds rate to a target range of 0.75% to 1%. This is the third increase since the financial crisis. The first increase was in December 2015. To put this into context, take a look at this chart showing long run historical trends in the Effective Federal Funds Rate:
The Fed's dot plot indicates most members are expecting to raise rates three times during 2017. The Fed started 2016 with expectations of raising rates four times, but backed off due to global market volatility. Whenever the rate increases occur, most Fed officials expect them to settle in the 3% to 4% range over the long run.
FR Risk Management clients have been asking how rising rates might impact REITs, BDCs and other alternative investment programs.
A couple common sense principles go a long way. To thrive in any environment, especially a rising rate environment, a fund must:
- Maintain a spread over cost of capital
- Prudently manage asset and liability mismatches. Refinancing short-term debt can be a problem if the yield on assets is fixed over a longer time period.
Usually the Fed will only raise rates if the economy is generally doing well, but the wrong portfolio positioning can make such rate increases very painful for investors.
REIT sensitivity to interest rates
Cohen and Steers have published research on REIT sensitivity to interest rates (here and here). Cap rates on properties are not as tightly correlated with interest rates as one might think. TH Real Estate reached a similar conclusion. REITs that grow cashflows at a rate exceeding the increase in cost of debt generally perform quite well, even in a rising rate environment. On the other hand, a REIT with a portfolio of long-term net lease properties that has either unhedged floating rate debt or an imminent need to refinance could get into trouble.
Periodic non-traded REIT valuations are often calculated on a discounted cashflow basis. A higher discount rate, all else equal, can drive down valuations. On the other hand, publicly traded REITs performed well during previous tightening cycles, providing a decent exit route for non-traded REITs.
Predicting the impact on BDCs
BDCs usually lend money at a floating rate interest rate (and if they lend for a fixed rate, it's usually a shorter time period so there isn't much duration risk). The catch is they often make loans with floors, and market interest rates have been below those floors for a while. If rates increase slightly, BDCs won't generate any additional yield on their investments.
On the other hand, BDC credit lines usually don't include floors, so a slight increase in rates immediately increases the cost of capital. Consequently most BDCs will generally experience a decline in net income if rates increase slightly, but could potentially experience significant gains if rates increase substantially, provided their portfolio companies can afford to pay. Good credit underwriting will be especially critical for BDCs in this part of the cycle.
An opportunity for alternative asset managers
A rising rate environment provides an opportunity for alternative asset managers to distinguish themselves. A large increase in rates would lead to a spike in volatility, but would also benefit REITs and BDCs that position themselves properly.
