An Active Manager s Take on REITs and Rising Rates

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1 MANAGER INSIGHTS JULY 2018 PUBLIC SECURITIES GROUP i REAL ESTATE 3Q 2018 An Active Manager s Take on REITs and Rising Rates The rise of 10-Year U.S. Treasury yields from the lows of mid-2017 has left investors to mull over some ageold questions on the relationship between Real Estate Investment Trusts (REITs) and rising interest rates. Contrary to popular belief, we find little empirical evidence to suggest that the historical correlations of these measures have been consistently negative or positive over time. History also shows that REITs have generally performed well when rates have moved higher during the reflationary period of an economic expansion. This makes sense to us, as we see interest rates as an output driven by numerous inputs (GDP ii growth, inflation, monetary policy, etc.). For this reason, knowing why rates are rising is central to the active manager s investment process. Equally important is a deep understanding of sector-level and geographic sensitivities to interest rates, as not all property types or markets are impacted in the same way. Effective investing, in our view, can be achieved through a combination of why, what and where. WE FIND NO CONSISTENT CORRELATION BETWEEN REIT PERFORMANCE AND RISING INTEREST RATES The belief that REIT prices are inversely correlated to interest rates a common misnomer, in our view can be easily dispelled with a simple regression analysis iii of daily changes. Since the 2006 inception of the Equity REIT Index, the correlation between changes in REIT prices and rates is, while positive at 0.26, iv very low. This is not to say that there is no correlation, rather we see no consistent correlation. As we researched correlations over more specific time periods, we found that the correlation between REITs and interest rates (represented by U.S. 10-year Treasury yields) varies greatly over time. For example, the rolling 60-trading-day correlations (approximating three months) between daily changes in REIT prices and rates have been as high as and as low as -0.64, with an average correlation of just As we delved deeper into the time periods when REITs and interest rates had particularly strong correlations with interest rates either positive or negative we found that the rising correlations were not REIT-specific. This view is supported by the performance of the broader market, as measured by the S&P 500 Index, which experienced rising correlations with interest rates in nearly all of the same time periods. EXHIBIT 1: ROLLING 60-TRADING DAY CORRELATION FTSE/NAREIT Equity REIT Index & U.S. 10-Year Yield S&P 500 Index & U.S. 10-Year Yield Source: NAREIT and Bloomberg as of 6/30/18. Data from 6/30/06 through 6/30/18. Index returns do not reflect deductions for fees, expenses or taxes. Indexes are not managed, and investors cannot invest directly in an index. Performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. There may be material factors relevant to any such comparison such as differences in the volatility, and regulatory and legal restrictions between the indexes shown and an actively managed investment strategy. See index definitions at the end of this report. Investing in real estate securities involves different risks, including the loss of principal. The tax treatment of returns of the asset classes listed above may differ given different tax treatment of income versus capital gain and other factors, such as the capital structure of the investment. Past performance does not guarantee results. Index performance is not indicative of fund performance. To obtain fund performance call or visit our website,

2 HISTORICALLY, IN PERIODS WHEN RISING RATES AND INFLATION WERE ACCOMPANIED BY ECONOMIC EXPANSION, REITS HAVE GENERALLY PERFORMED WELL As stated above, we believe it is important to understand that interest rates are an output driven by numerous inputs including monetary policy, inflation, investor sentiment and GDP growth, among others. In terms of REITs and performance, it is not as simple as rates are rising; rather, it is understanding why rates are rising. If rates are driven higher by inflation, then the historical inflationary nature of real estate values is a key investment characteristic of REITs and other real estate investments. During periods of economic growth, REITs can increase rents as demand for space increases. If rates are rising due to a growing economy, we would expect that factors in place during a time of economic expansion, such as income growth and demand for goods and services, may generally benefit REITs. Exhibit 2 supports this point by showing that REITs had positive returns in the vast majority of periods when GDP was positive. EXHIBIT 2: U.S. REIT AND NOMINAL GDP Trailing 12 Month Equity REIT Index Total Return Source: Bloomberg and U.S. Bureau of Economic Analysis. Represents quarterly returns and GDP data from March 2006 through March REITs represented by the FTSE/NAREIT Equity REIT Index. Index returns do not reflect deductions for fees, expenses or taxes. Indexes are not managed, and investors cannot invest directly in an index. Performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. There may be material factors relevant to any such comparison such as differences in the volatility, and regulatory and legal restrictions between the indexes shown and an actively managed investment strategy. See index definitions at the end of this report. Investing in real estate securities involves different risks, including the loss of principal. The tax treatment of returns of the asset classes listed above may differ given different tax treatment of income versus capital gain and other factors, such as the capital structure of the investment. Past performance does not guarantee results. Index performance is not indicative of fund performance Year-Over-Year Nominal GDP Growth 10 U.S. REITS Vs. U.S. EQUITIES Since the inception of the Equity REIT Index in March 2006, there have been eight periods when 10-Year U.S. Treasury yields rose by more than 50 basis points. Within these periods of notable rate increases, the performance of REITs was mixed, with REITs generating positive returns in 50% of periods, while outperforming broader equities overall. As highlighted in Exhibit 3, REITs had positive returns in seven of the eight three-month periods after the rise in rates. Overall, U.S. REITS outperformed U.S. equities by an average of 3.44% in these periods. EXHIBIT 3: REITS Vs. S&P 500 INDEX DURING PERIODS OF RISING RATES ( ) RISING-RATE PERIOD CHANGE IN 10-YEAR U.S. TREASURY YIELD DURING RISING RATES THREE MONTHS AFTER RATE RISE EQUITY REIT INDEX S&P 500 EQUITY REIT INDEX S&P /30/06 6/29/ /31/08 5/31/ /31/08 12/31/ /31/10 3/31/ /31/12 1/31/ /30/13 12/31/ /30/15 6/30/ /29/16 1/31/ AVERAGE Sources: Bloomberg, NAREIT, S&P through 6/30/18. Note: Returns for both the Equity REITs Index and S&P 500 Index are total returns. The Equity REIT Index underperformed the S&P 500 Index in periods highlighted in orange. The above indexes do not reflect deductions for fees, expenses or taxes. Indexes are not managed, and investors cannot invest directly in an index. Performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. There may be material factors relevant to any such comparison such as differences in the volatility, and regulatory and legal restrictions between the indexes shown and an actively managed investment strategy. See index definitions at the end of this report. Investing in real estate securities involves different risks, including the loss of principal. The tax treatment of returns of the asset classes listed above may differ given different tax treatment of income versus capital gain and other factors, such as the capital structure of the investment. Past performance does not guarantee results. Index performance is not indicative of fund performance. 2

3 REITS Vs. CORPORATE BONDS In order to fundamentally understand the connection between REITs and rising rates, we think it is also important to recognize the distinct investment characteristics of REITs versus bonds. While REITs may be similar to bonds in that they generally distribute steady streams of current income, this does not mean that REITs will act like bonds in a rising-rate environment, for two reasons. 1. Bonds have a fixed coupon, while REITs do not. An investor s coupon payment is generally fixed for the life of a bond; thus, it does not rise or fall with a change in economic growth or market interest rates. On the other hand, annual REIT dividend distributions have risen by 2.89% per year since the 2006 inception of the Equity REIT Index. If rising rates are due to rising economic growth or inflation, we believe that REITs should stand to experience improving demand from job growth and income growth, which in turn is likely to drive earnings higher and allow dividends to accelerate. 2. The face value of a bond is fixed; real estate values are not. The face value of a bond does not change during the investment period, and therefore there is no inflation protection to the bondholder. However, our research shows that the growth in real estate values has generally outpaced inflation. We believe that the potentially higher asset growth of REITs relative to inflation is a very important feature of REITs and other real estate investments. The table below compares the historical performance of REITs to corporate bonds in periods of rising rates. Notably, bonds provided a negative total return in six of the eight rising-rate periods of our study, underperforming REITs by an average of 2.59% during these periods. We believe that the positive sensitivity of real estate to inflation is a likely driver of resilient REIT performance in periods of economic expansion. EXHIBIT 4: REITS Vs. CORPORATE BONDS DURING PERIODS OF RISING RATES ( ) RISING-RATE PERIOD CHANGE IN 10-YEAR U.S. TREASURY YIELD EQUITY REIT INDEX DURING RISING RATES THREE MONTHS AFTER RATE RISE ICE BOFAML GLOBAL CORPORATE INDEX EQUITY REIT INDEX ICE BOFAML GLOBAL CORPORATE INDEX 11/30/06 6/29/ /31/08 5/31/ /31/08 12/31/ /31/10 3/31/ /31/12 1/31/ /30/13 12/31/ /30/15 6/30/ /29/16 1/31/ AVERAGE Sources: Bloomberg, U.S. Bureau of Labor Statistics, and Morningstar. The above indexes do not reflect deductions for fees, expenses or taxes. Indexes are not managed, and investors cannot invest directly in an index. Performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. There may be material factors relevant to any such comparison such as differences in the volatility, and regulatory and legal restrictions between the indexes shown and an actively managed investment strategy. See index definitions at the end of this report. Investing in real estate securities involves different risks, including the loss of principal. The tax treatment of returns of the asset classes listed above may differ given different tax treatment of income versus capital gain and other factors, such as the capital structure of the investment. Past performance does not guarantee results. Index performance is not indicative of fund performance. WHEN INTEREST RATES RISE, ACTIVE MANAGEMENT MATTERS Although we maintain that REITs have the potential to perform well in a rising-rate environment, it s important to recognize that the performance of underlying REIT sectors has been somewhat uneven. We attribute these results to several factors, including sector-level sensitivities to economic drivers and unique supply-demand characteristics. These differences open up a diverse opportunity set for active managers to adjust sector-level exposures throughout the real estate cycle. In our view, one of the telltale signs of interest-rate sensitivity lies in the average lease term of a particular property type. Average lease terms can vary from as short as nightly for the hotel sector to 10-or-more years for the net lease and health-care sectors. We maintain that if rates are rising because of improving economic growth or rising inflation, sectors with short lease terms are better positioned than those with long lease terms, because they can adjust rental rates upward more quickly. On the other side of the spectrum, companies with long lease terms are limited in their ability to adjust rental rates upward, making them much more sensitive to interest rate moves. 3

4 This view is supported by a historical look at the returns of key real estate sectors, organized in Exhibit 5 by average lease terms (with the longest lease terms on the left and the shortest on the right). Although the relative performance of many of these sectors changes over time, we see several key takeaways from this analysis, looking at the tail ends of the lease-term spectrum. One is that the Lodging/Resorts sector, in which economic growth can quickly lead to high levels of demand for the sector, outperformed other sectors on a fairly consistent basis. The short lease term allows both occupancy levels and daily rates to quickly increase, which can drive earnings higher. The self-storage and apartment sectors also fared relatively well, but the outperformance of these sectors was less consistent. EXHIBIT 5: THE DIVERSE SECTORS THAT COMPRISE THE LISTED REAL ESTATE U N I V E R S E HEALTHCARE SHOPPING CENTERS INDUSTRIAL SINGLE FAMILY RENTAL SELF STORAGE Longer Lease Term Shorter Lease Term FREE-STANDING NET LEASE REGIONAL MALLS OFFICE APARTMENT LODGING/ RESORTS Source: Brookfield Investment Management. For illustrative purposes only. We attribute the underperformance of two sectors health care and free standing net lease to their long lease terms, which limit the ability to raise rental rates amid improving demand, and cash flows that tend to be more interest-rate sensitive. We note that the average difference between the best-performing and the worst-performing sectors during these periods of rising rates, as highlighted below in Exhibit 6, is over 28%, which underscores the importance of actively managing real estate securities portfolios. EXHIBIT 6: FTSE/NAREIT EQUITY REIT INDEX SECTOR OVER PERIODS OF RISING INTEREST RATES ( ) RISING-RATE PERIOD LODGING/ RESORT SELF STORAGE APARTMENT INDUSTRIAL Source: NAREIT as 6/30/18. Cell highlighting represents the range performance of each sector during the period noted, with dark blue representing the most positive returns, and dark orange representing the most negative returns. The above index sector returns do not reflect deductions for fees, expenses or taxes. Indexes are not managed, and investors cannot invest directly in an index. Performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. There may be material factors relevant to any such comparison such as differences in the volatility, and regulatory and legal restrictions between the indexes shown and an actively managed investment strategy. See index definitions at the end of this report. Past performance does not guarantee results. Index performance is not indicative of fund performance. OFFICE RETAIL HEALTH CARE FREE- STANDING BEST SECTOR- WORST SECTOR 11/30/06 6/29/ /31/08 5/31/ /31/08 12/31/ /31/10 3/31/ /31/12 1/31/ /30/13 12/31/ /30/15 6/30/ /29/16 1/31/ AVERAGE

5 OUR CLOSING PERSPECTIVE Based on our research into the long-term historical returns of REITs, we cannot point to a consistent correlation either positive or negative between the performance of REITs and changes in interest rates. We found that REIT performance was mixed over the eight largest rising-rate periods since the 2006 inception of the Equity REIT Index; however, we also note the resiliency of the asset class in the months that followed those increases. Over the time frame of our study, REITs generated positive performance in all but one of the eight periods and generated higher returns, on average, than broader U.S. equities. Should interest rates continue to notch higher in the coming months, we believe it s important to remember why interest rates are rising, in the context of what drives REIT fundamentals. The U.S. is in a reflationary stage of economic expansion, marked by solid trends of earnings growth and jobs growth. In our view, the negative factors generally associated with rising nominal interest rates will be largely offset by these positive trends, coupled with low levels of new supply in many U.S. markets. We emphasize the importance of actively managing a REIT allocation, since not all REIT sectors (and companies) carry the same degree of interest-rate sensitivity; active managers can structure portfolios accordingly. Although we have focused this analysis on the U.S. market; we also recognize that the global universe of real estate securities provides diverse geographic investment opportunities. These varying geographies are often at different points in the economic cycle and provide exposure to differing economic drivers and returns, across the various REIT sectors. Based on the considerations outlined above, we view interest rates as one of many variables to consider in building a diversified portfolio. Individual investors can gain access to our longstanding institutional expertise through actively managed strategies offered in separately managed accounts, mutual funds, UCITS funds, closed-end funds and private hedge funds. IMPORTANT DISCLOSURES Must be preceded or accompanied by a current prospectus if used in connection with a Brookfield mutual fund purchase. You can obtain a prospectus for a Brookfield mutual fund by calling or visiting our website Mutual fund investing involves risk. Principal loss is possible. Below are real estate related risk disclosures that apply to the Brookfield Mutual Funds. Property values may fall due to increasing vacancies or declining rents resulting from unanticipated economic, legal, cultural or technological developments. REITs are dependent upon management skills and generally may not be diversified. REITs are subject to heavy cash flow dependency, defaults by borrowers and self-liquidation. 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