A regular occurrence in financial markets is that some trend persists for so long that investors and businesses start to make assumptions that it will always be so. In one sense, this is human nature as we tend to extrapolate what tomorrow will look like today... and this is the case, most of the time.
Maybe the best, recent example of this was the housing bubble and the ensuing crash. The housing bubble was built on the assumption that home prices would always rise as they had for much of the past few decades. This led to risky speculation and exotic securities that were considered acceptable as the value of the underlying asset would appreciate, so even if a homeowner couldn't make payments, the underlying collateral would have value.
Of course, many of these securities became worthless as the housing market collapsed and spiraled lower. Basically, the fundamental 'gravity' of home prices outpacing gains in incomes could only continue for so long.
A similar situation is brewing in REITs and other companies with similar structures. These trends can be seen in popular exchange traded funds (ETF) that invest in REITs like Vanguard Real Estate ETF
In essence, this business model makes sense in an environment of low rates but not so much in an environment where rates will stay elevated for longer which seems likely given recent economic data and inflation trends.
First, it's useful to review how REITs work. In essence, they lease space, rent it to landlords, and then collect rent which is distributed to shareholders as income. It's immediately clear that this business model becomes unviable in an environment of rising rates but increasing vacancies due to economic stress.
This means that the REIT's financing costs are increasing, while the rent it collects from landlords could be declining at the same time. Simultaneously, the yield is what makes a REIT attractive in addition to the prospects of appreciation of its holdings. However, this yield is less attractive when investors can lock in a 5% guaranteed rate with zero risk.
In contrast, the REIT is also now exposed to its underlying assets losing value which is likely in a recessionary situation, especially in markets like commercial real estate where many older office buildings and retail locations remain vacant.
Therefore, investors should pay attention to this pocket of the market as a source of market stress, especially as many of the investors who buy REITs typically do so because they are less volatile and produce a nice income stream.
