Last year’s rising mortgage rates were straight out of the record books. Reaching 6.73% in December, 2022 mortgage rates rose by the highest margin of any year on record. Many investors and homebuyers alike are wondering what to expect from mortgage rates in 2023. Will the rising rates cool? And how will that affect the performance of mortgage-linked investments like REITs? In this guide, we’ll discuss the 2023 mortgage rate outlook and what you need to know about investing in REITs going forward.
What’s Going On With Mortgage Rates?
The rising rates of 2022 were a result of the Federal Reserve’s aggressive tightening of monetary policy in response to persistently high levels of inflation. As inflation starts to recede, many economists are predicting that the Fed will slow or halt their interest rate hikes and mortgage rates will fall over the course of 2023.
Conversely, if inflation proves to be stickier and does not decline to an acceptable level, the Fed may continue to raise interest rates, increasing the likelihood that mortgage rates will continue to rise. This is because mortgage rates tend to rise when Treasury yields rise, and Treasury yields rise when interest rates rise.
Like most economic forecasts, predicting mortgage rates is not an exact science. With that said, industry experts like Fannie Mae, Freddie Mac, and National Association of Realtors, among others, are predicting 30-year rates will stabilize somewhere in the 5.7% to 6.4% range by the end of 2023.
What Does That Mean for REITs?
Real estate investment trusts (REITs) are closed-end funds that buy, develop, manage, and sell real estate assets. REITs can be publicly traded and are easy to buy like any stock on the exchange. They can also be non-traded, which may shield an investor from volatility when the markets go through more violent corrections.
In a rising-rate environment, however, there are important considerations to keep in mind before investing in REITs. Rising rates can pose threats to the price and value of REIT shares. Though the exact relationship is hard to predict, some data indicates that prices rise and returns fall because of the underlying REIT business model. Since they are dealing in real estate and often acquire mortgage debt to buy and manage the underlying properties, rising mortgage rates increase the cost of doing business and therefore increase the price per share. It also makes it more difficult to earn the income that is passed through to shareholders, thereby reducing returns.
Take a look at the chart below which illustrates the performance of REITs in rising-rate environments, or periods of time when the Fed tightens monetary policy. REIT performance tends to decline during this period:
Not only that, but REITs are often seen as a bond-substitute. If newly issued bonds have interest rates that are on par with the returns from an existing REIT, then investors may be more likely to sell their REIT shares in favor of, say, a Treasury bond, which is a significantly less risky asset.
Other data shows that because rising rates are generally correlated with improving financial conditions, higher interest rates actually increase returns for REITs. Because there is no clear consensus on how REITs behave in a changing rate environment, it’s difficult to predict what’s in store for 2023.
Since interest rate hikes will continue for the foreseeable future, albeit in smaller increments, mortgage rates may continue to stay elevated as compared to the last several years. Even if mortgage rates do fall, they are unlikely to reach the pre-pandemic levels. Overall, mortgage rates are expected to remain volatile until the Fed rate hikes end.
All that said, REITs can still be a great addition to a portfolio as the underlying factors that promote growth are usually present in a high-interest-rate environment, but it’s important to thoroughly research before buying. Here are some general pros and cons of REITs to help you make your decision.
- Diversification: REITs add additional portfolio diversification since the underlying asset is real estate, which has a low correlation with traditional asset classes like stocks and bonds. Real estate is often seen as a hedge against inflation, and because of the low correlation, it can cushion your portfolio from market fluctuations.
- High dividend yields: In general, REITs are required to pay at least 90% of taxable income to shareholders, meaning they usually provide higher dividends when compared to other types of investments. Even if yields fall in a rising-rate environment, they may still be more attractive than a dividend-paying stock, for instance.
- Liquidity: REITs are a highly liquid way to add real estate exposure to your portfolio. Buying and selling properties takes a lot of time, effort, and capital, which makes investing in individual properties unrealistic for many investors. With an REIT, you can purchase a fractional interest in a range of properties that can be bought and sold easily on the open market. This allows you to free up your funds quickly in the event you need them for something else.
- Sensitive to interest rates: As mentioned, REITs are sensitive to changes in interest and mortgage rates, which can make it difficult to predict your potential return, especially in an unprecedented rate environment such as the one we are experiencing in 2023.
- Taxes: Dividends on other investments can usually receive the preferential long-term capital gain tax rate if certain requirements are met. With REITs, however, dividends are taxed as ordinary income, which can significantly increase your tax liability if you are in a higher tax bracket.
- High fees: Some REITS may charge high transaction and management fees that get buried in the fine print. This can lead to reduced returns for investors. Be sure to do thorough research before adding REITs to your portfolio.
We’re Here to Help
At Grace Wealth Management Group, we are here to help investors navigate REITs in a changing rate environment. We have more than two decades of experience helping clients pursue their financial goals, and we specialize in working with real estate investors. If you have questions about adding REITs to your portfolio, or you would like to review the REITs you already own, schedule an appointment here or call me at (949) 631-3840 x2 or email email@example.com.
About Jim Peters
Jim Peters is an independent financial advisor and the founder of Grace Wealth Management Group, Inc., a full-service financial firm committed to helping people pursue their financial goals. With more than 24 years of experience in the industry, Jim combines his extensive knowledge with his genuine interest in helping people pursue financial independence. Beyond his experience, he is certified as both a Chartered Life Underwriter® (CLU®) and Chartered Financial Consultant® (ChFC®) professional, meaning he has advanced training and knowledge in financial planning and insurance. Based in Irvine, California, Jim specializes in working with individuals, families, and businesses throughout Orange County. To learn more, connect with Jim on LinkedIn or visit www.financialadvisorirvine.com.