South Africans across the board have felt the pinch of the recent continuous interest rate hikes by the South African Reserve Bank. The reason for this is simple: higher interest rates means increased cost of borrowing. And while this affects most individuals monthly repayments, higher interest rates also have another major impact on the balance sheet of Real Estate Investment Trusts (REITs).
The increased cost of borrowing means REIT balance sheets suddenly carry a host of possible risks. Below are six of the major risk areas that could apply to a REITs balance sheet.
1. Property valuation risk
One of the most prominent risks for REITs is what higher interest rates mean for a property valuation. The simple reason for this is that higher interest rates decrease the value of assets held by REITs, resulting in a decline in such trust’s Net Asset Value (NAV).
In addition, the discount rate used to value future cash flows from properties may also increase, resulting in lower property valuations. Or, in some cases, cap rates in valuation models may go up, which will cause property values to drop as risk-free rate increases.
REITs may also see a drop in share value based on the cost of debt and reduced cash flow. This risk however may be managed through a hedging policy such as interest rate swaps.
And while debt remains the same, due to a drop in underlying property values, REITs will experience higher Loan-to-Value (LTV) or gearing.
The final risk associated with property valuation is tenants defaulting on payment, which in turn will affect property value.
2. Liquidity Risk
Higher interest rates can deter potential property buyers. This can result in a reduced demand and stagnant sales, that can inadvertently tie up capital and in turn, impact liquidity.
The higher cost of borrowing also affects liquidity as it reduces profitability and cashflow — in particular if a REIT is reliant on debt for financing.
3. Capital Expenditure Risk
The decrease in property valuations impacts a REITs ability to raise capital and fund capital expenditure. Similarly, the increase in the interest rate expense reduces profitability and liquidity and will have an impact on how capital expenditure is funded.
4. Tenants defaulting (Credit Risk)
As mentioned, tenants may be affected by the higher interest rates. Due to higher borrowing costs and reduced cashflow, tenants may begin to default on their rental obligations.
The rising increase in costs may also force REITs to review and increase rental charged to tenants further impacting a tenant’s affordability and subsequently increasing the tenants risk of defaulting.
The impact of interest rates will affect the wider population and possibly result in a recession in spending. This decreases foot traffic at retail malls and stores which has a direct impact on businesses, especially smaller tenants who rely on the daily business to keep up with rental obligations.
5. Vacancy/Occupancy Risk
As it becomes increasingly expensive for tenants to finance leases, renting out vacant units or renewing existing leases may stagnate.
A higher interest rate environment and a resultant buyers’ market can also lead to stagnant property sales and a longer lead time to attract new tenants.
An overall decline in liquidity due to the increase cost of borrowing also tends to result in a failure to maintain properties and meet needs of tenants. This is another factor that can lead to tenants vacating a property, further adding to vacancy risk.
6. Tax Risk
Internal on-lending structures are common to REIT groups. As such, increased interest rates will result in increased interest income in the lender’s hands — negatively impacting its rental income ratio which needs to be maintained at 75% of gross income.
As a result, where a REIT or controlled company in relation to a REIT fails to maintain a 75% rental income level, it will not qualify for a tax deduction of its distributions.
Depending on internal structures, REITs are also potentially exposed to the risk of incurring unproductive interest which may not qualify for tax deduction. The quantum of this risk increases as interest rates increase. And so, with higher credit risk, REITs should ensure they maximise doubtful and bad debt deductions for tax purposes while ensuring such deductions are justifiable.
A REITs share price might also be affected by rising interest rates, causing some employee share schemes to fall underwater. But exiting or cancelling share schemes must always be treated with careful tax consideration. The same can be said in a situation where REITs cancel or exit interest rate hedging instruments.
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