A rate rise reaches a REIT through two doors: the cap rate on its buildings and the coupon on its debt. Sizing each shows which one the share price is really pricing.
Rising rates reach a REIT through two channels: the cap rate investors apply to its buildings, and the coupon it pays on debt that reprices. On an illustrative REIT at 35 per cent LTV, a 100 basis point rise with half passed into cap rates cuts NAV per share by 12.8 per cent, from $32.50 to $28.33, while the extra interest cuts FFO per share by only 3.3 per cent. The value channel is roughly four times the earnings channel, and leverage sets its size.
Worked in full in REIT Analysis and Valuation by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A fictional REIT, figures in $ millions except per share. The pass-through, the share of a rise in bond yields that ends up in cap rates, is an assumption, not a law: it varies by sector, by starting spread and by the reason rates rose. It is the input to argue about, so the result is shown across its whole range.
| Input | Value |
|---|---|
| Forward cash NOI | 550.0 |
| Cap rate (gross asset value 10,000.0) | 5.50% |
| Debt, average coupon 4.00% | 3,500.0 |
| Floating, plus maturing within a year | 25% + 10% |
| Recurring G&A | 40.0 |
| Shares | 200.0 |
| Rise in rates; pass-through to cap rates | 100 bp; 50% |
NAV = 550.0 / 5.50% − 3,500.0 = 10,000.0 − 3,500.0 = 6,500.0, or $32.50 a share
FFO = 550.0 − 40.0 − 3,500.0 × 4.00% = 550.0 − 40.0 − 140.0 = 370.0, or $1.850 a share
At NAV the shares trade on 17.6x FFO.
New cap rate = 5.50% + 50% × 100 bp = 6.00%
Gross asset value = 550.0 / 6.00% = 9,166.7, down 8.3%
NAV = 9,166.7 − 3,500.0 = 5,666.7, or $28.33 a share, down 12.8%
Excel: =(NOI/(Cap+PT*Shock)-Debt)/Shares
The debt does not move, so an 8.3 per cent fall in property value becomes a 12.8 per cent fall in equity value: 1.54 times, which is one over one minus LTV. LTV itself rises from 35.0 to 38.2 per cent without a dollar borrowed.
Debt that reprices = 35% × 3,500.0 = 1,225.0
Extra interest = 1,225.0 × 100 bp = 12.25
FFO = 370.0 − 12.25 = 357.8, or $1.789 a share, down 3.3%
If the market held the 17.6x multiple, the price would fall only to $31.42. It rarely does, because the multiple embeds the same cap rate the value channel has just moved. The rest of the debt reprices as it matures, so the earnings hit keeps arriving for years; the cap rate hit is priced on the day.
| Pass-through | Cap rate | NAV per share | Change |
|---|---|---|---|
| 0% | 5.50% | $32.50 | 0.0% |
| 25% | 5.75% | $30.33 | −6.7% |
| 50% | 6.00% | $28.33 | −12.8% |
| 75% | 6.25% | $26.50 | −18.5% |
| 100% | 6.50% | $24.81 | −23.7% |
| Debt | LTV | NAV change | FFO change |
|---|---|---|---|
| 2,500.0 | 25.0% | −11.1% | −2.1% |
| 3,500.0 | 35.0% | −12.8% | −3.3% |
| 4,500.0 | 45.0% | −15.2% | −4.8% |
Pass-through dominates: it moves the answer from nothing to nearly a quarter of NAV. Leverage widens it, and the debt's tenor decides how fast the earnings channel bites: with all debt fixed long, the immediate FFO hit is nil; with all of it floating, 9.5 per cent.
The offset is income. If rates rise because inflation has risen, rents may follow. With 3.0 per cent more NOI the NAV fall shrinks from 12.8 to 8.6 per cent. To cancel a 50 basis point cap rate rise entirely, NOI must rise 9.1 per cent, which only short-lease sectors can do quickly. That is why the same rate move hits a long-lease net-lease REIT harder than one with leases that reset every year.
The method needs five inputs from the filings and one judgement. Take forward cash NOI by segment, the cap rate the NAV uses, net debt, the share count, and the debt maturity schedule split into floating, fixed maturing within the horizon and fixed beyond it. Then choose the pass-through, and show it as a range rather than a point, because it carries most of the answer. Compute the new NAV per share and the FFO effect year by year as fixed debt rolls. Compare the result with the move in the share price since rates began to rise: if the shares have already fallen further than the value channel implies, the market is pricing something else, usually growth or a funding problem.
Judging a REIT's rate exposure from its debt alone. Analysts tally floating debt and maturities, find a 3.3 per cent FFO hit, and call the company well hedged. The larger exposure is in the asset value, which no swap protects, and which the market prices as soon as the yield curve moves. The second mistake is to apply a cap rate change to NAV without reading what the share price already implies: if the shares trade below NAV, part of the rise may already be in the price, which the implied cap rate makes visible.
The book's complete analysis builds NAV, the implied cap rate and the sensitivity on one REIT, and shows why the implied cap rate does not move when you change the cap rate input; the live model is in the free workbook for this case.
Because property is valued as income over a cap rate, and cap rates tend to move with bond yields, while REIT debt amplifies any change in value for the shareholders. In the illustrative case a 50 basis point cap rate rise cuts property value 8.3 per cent and NAV per share 12.8 per cent at 35 per cent LTV. Debt repricing adds a smaller hit to FFO.
Not if income grows with them. When rates rise because inflation is higher, rents may follow. In the worked case, 3.0 per cent of extra NOI cuts the NAV fall from 12.8 to 8.6 per cent; NOI would need to rise 9.1 per cent to offset a 50 basis point cap rate rise entirely. Short leases reprice faster than long fixed ones.
Floating and near-term maturing debt passes higher rates into FFO at once; long fixed debt delays it. With 35 per cent of $3,500M of debt repricing, a 100 basis point rise costs $12.25M and 3.3 per cent of FFO. All fixed, the immediate hit is nil; all floating, it is 9.5 per cent.
This article is one calculation from REIT Analysis and Valuation. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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