Will Real Estate Fail When Interest Rates Rise?

Abstract

The current yield on the 10-year T-bond bottomed out at 49.9 bps in 2020 and has since risen to 316.7 bps, a 535% proportionate increase. Consequently, 7–10-year and 10–20-year US Treasuries delivered total returns of −15.0% and −27.7%, respectively. Institutional and retail investors are actively seeking bond substitutes in response to a fear that the US economy has embarked on a multidecade-long era defined by ever-increasing interest rates. Commercial real estate is the first bond substitute they are considering. Unfortunately, data since 1971 strongly support the conclusion that publicly traded real estate investment trusts (REITs) carry a positive interest rate loading of sufficient size that their use as a bond substitute is likely to make the situation worse. In contrast, data since 1977 support the conclusion that private direct ownership of institutional bricks and mortar carries no such interest rate factor loading. Carried to its logical conclusion, these observations suggest the exploration of something like a 130/30 portfolio (130% long the NFI-ODCE Index and 30% short the FTSE Nareit All REITs Index).