The anticipated cut to the cash rate next week may be prompting investors in listed property to boost their holdings, but it’s worth knowing that the relationship between REITs and rates isn’t always straightforward.

Along with regulated utilities, infrastructure companies and financials – which will be addressed in a later article – real estate investment trusts are widely held to respond most markedly to changes in interest rates, and for a couple of different reasons.

The Reserve Bank of Australia is tipped by some economists to cut the historically low cash rate of 1.5 per cent by 0.25 per cent when it meets next week. The RBA last moved in August 2016 when it cut its cash rate to 1.5 per cent because of weakening economic growth.

The effect of falling rates

Because funding costs usually comprise the largest business expense for companies, falling rates reduce the expense of servicing that debt. All else being equal, this can lead to an increase in profits and greater demand for shares, which tends to push share prices higher.

Of course, it also works the other way - if interest rates rise, the companies' cost of servicing debt increases, profitability declines and share prices fall.

Investors' preference for certain types of stocks if they're specifically seeking income become more or less attractive depending on where interest rates are headed.

If rates are expected to decline, dividend-yield stocks such as those held by property securities may become more attractive compared to other interest-bearing account options.
Property trusts and utilities are particularly sensitive to changes in interest rates, because investors usually seek them out for their yield potential.

Morningstar senior equity analyst Tony Sherlock says certain types of listed property securities are more exposed to interest rate movements than some infrastructure assets such as utilities like APA Group (ASX: APA) or toll road operator Transurban (ASX: TCL).

"Office real estate investment trusts, particularly those with higher quality holdings, are the assets that are probably going to benefit most from lower interest rates," Sherlock says.

This is because corporate leases in the commercial assets that underpin these companies are typically in place for between seven and 12 years.

"So, if bond yields fall [as occurs when official rates decline], then they are more sought after. They also provide a more stable income stream," Sherlock says.

Buyer beware

However, there are some caveats to the appeal of property securities relative to interest rate movements. As examples, Sherlock singles out Dexus (ASX: DXS) and Goodman Group (ASX: GMG) – both pure-play property companies in their respective categories.

Dexus is focused almost entirely on Australian office properties, which comprise about 85 per cent of the group's total assets.

Goodman Group's assets are long-lease industrial properties spanning the US, Europe, China and Australia.

Sherlock says Dexus' share price may respond positively if interest rates fall slightly, for the supply-demand reasons explained earlier, but also because its debt is held in Australia and therefore linked to local interest rates.

But he says investors must also be mindful of who the largest investors in such companies are.

"When looking at REITs, if interest rates change you've got to look at who is doing the majority of the buying and selling."

Sherlock points out that the largest holders of these stocks are institutional, whose global perspective also extends to their outlook on interest rates.

"The markets are global. It's not our Australian retail investors that are moving these stocks around," he says.

Such investors pay more attention to longer-term indicators such as five-year and 10-year bond yields, which have already fallen to historical lows in recent months.

"So even if there is a cut from 1.5 to 1.25 per cent by the RBA, it isn't going to have any impact on the share price, because it's already priced in," Sherlock says.

"And for those REITs with a global focus like Goodman Group, Lend Lease and Cromwell Group, Australian interest rate movements have a negligible impact."