In January of 2022, inflation rose by .6%, which equates to a 7.5 annual rate – the highest since 1982. This consumer price index (CPI) reading came in higher than expected and presents a challenge for both regulators and financial markets. The traditional tool used by the Federal Reserve (“The Fed”) to combat inflation is to raise interest rates in an effort to cool off the economy. But, as rates rise, the cost of capital also rises, which has the potential to be a negative for investments. It doesn’t have to be.
In this article, we are going to present ten investment ideas for an environment where interest rates are rising. We will describe what they are, how they benefit from rising rates, and the risks and benefits of allocating capital to each. By the end, readers should be able to identify one or more ideas that are a suitable fit for their own commercial real estate investment objectives.
At First National Realty Partners, we are a private equity firm that specializes in the acquisition and management of grocery store anchored retail shopping centers. Because our properties are partially financed with debt, we pay close attention to movements in interest rates and proactively seek to mitigate them when necessary. If you are an accredited investor and would like to learn more about our current commercial real estate investment opportunities, click here.
Pre-Investment Considerations
Before any individual allocates capital to an investment, they should first ask themselves several key questions:
- How Much Capital Do I Have To Invest? The amount of capital available to invest will drive potential investment options because some options have minimum investment amounts while others don’t. For example, some of the items on the list below have a high minimum investment – like private equity real estate ($25,000+) – while others like stocks have a much lower minimum investment ($25 – $100).
- What Return Do I Need To Achieve? For whatever reason, some investors want to achieve a high annual return, like 12%+ while others are comfortable with a lower return, like <6%. To achieve these targets, investors will need to gravitate towards certain asset classes.
- How Much Risk Am I Willing To Take? Risk and return are closely correlated. Investors who want to achieve a higher return will need to take more risk, which exposes them to more potential price volatility. Those who aren’t as comfortable with risk will need to be comfortable with lower, but more stable, returns.
- What Is My Time Horizon? As a general rule, short-term investments tend to have lower returns. While those that require a longer term time horizon will likely offer a higher return. If an individual could potentially need their money in one to three years, they should stick with shorter, more liquid investments.
In other words, every individual’s financial circumstances are unique. So, before making any capital allocation decisions, they should take stock of their own needs and preferences so they can find the investment option that is most suitable for their circumstance.
Why You Need To Prepare Your Portfolio For Rising Rates
The consequences of rising rates are complex. But, they can be generalized by stating that rising interest rates make debt more expensive. So, any company (or project) that relies on debt to fund future growth – like the construction of a new factory or the hiring of new staff – will find it more expensive to finance these projects. As a result, the bar for profitability is higher and many projects ultimately get scrapped, which is how the economy slows down.
So, rising rates are typically a negative for some types of investments – particularly those companies who rely on low cost debt to fund growth. But, they can also be a positive for others. So, in a rising rate environment, it is necessary for investors to position their portfolio away from those investments that will suffer and towards those that stand to benefit.
Tips for Investing for Rising Rates
Below are three general tips that can be used to position an investment portfolio for higher rates ahead.
Avoid Floating Rate Debt
Interest rates are cyclical. When the economy is hot, the Federal Reserve pursues policies that cause rates to go up, which cools off the growth. But, if growth cools off too much, the Federal Reserve will move the other way and pursue policies that cause rates to decline. Lower rates fuel future growth and the economic growth cycle begins all over again.
Because the length of the interest rate cycle is unpredictable, it is generally a good idea to avoid floating rate debt. As interest rates rise, so do interest payments, which can cut into profits. Instead, investors should do their best to lock into long term, fixed rate debt at the lowest rate possible.
Take Advantage of Floating Rate Bonds
Debt goes both ways. On the borrower side, it is best to fix the rate for the long term. But, on the lender side, rising rates can mean higher returns. For this reason, fixed income investors may benefit from floating rate bonds.
With Stocks – Aim For Dividend Growth
With regard to equities, a rising interest rate environment is generally a negative for growth names. But, stable, mature companies that generate significant amounts of free cash flow and return this to shareholders in the form of dividends generally hold up better. This is not to say that their share price will rise, but they may not fall as quickly or or may beat their established benchmarks. The income produced by dividends can help offset any losses in share price.
With these general tips in mind, below are ten investment ideas for a rising interest rate environment.
Idea #1: Banks & Brokerage Firms
Again, a rising rate environment tends to be good for lenders because they earn more interest on their floating rate loans. For this reason, those who like the stock market may find value in the stocks of those who lend money. Specifically, banks and brokerage firms like Wells Fargo, JPMorgan, or Goldman Sachs tend to fare well when interest rates rise.
Aside from the rising profits, the benefit of investing in financial services firms in a rising rate environment is that they tend to be mature, stable companies. In addition, they are highly regulated and their publicly traded shares provide investors with a high degree of liquidity.
The downside of financial services firms in a rising rate environment is that investors must take a careful look at their loan portfolio. If they have a high proportion of fixed rate loans, they may not benefit as much from rate increases. In addition, banks need to increase the amount of interest that they pay on deposit accounts, which can expose them to some interest rate risk.
Idea #2: Private Equity Real Estate
Private equity firms invest in the privately held equity of other companies, including those that own real estate. In a typical deal, a private equity firm does all of the hard work of finding, underwriting, financing, and managing a commercial real estate asset. Investors who partner with private equity firms provide capital and receive periodic distributions. They have no day to day role in the management of the property.
In general, private equity commercial real estate performs well in a rising rate environment because operators have the ability to raise rents to offset the higher interest that must be paid if the debt has a floating rate. In addition, real estate values also tend to rise along with rents.
But, on the downside, properties financed with variable rate debt are exposed to interest rate risk. As interest rates rise, the amount of money left over for investor payouts decreases. If rates rise high enough, it can even impact a property’s ability to pay the operating expenses – which is a worst case scenario.
Idea #3: Real Estate Investment Trusts (REITs)
A Real Estate Investment Trust is a company that owns, operates, and/or finances commercial real estate. Under this structure, investors can purchase a fractional share of an existing, diversified real estate portfolio. REITs can be publicly traded or privately held and may specialize in certain property types like multifamily or office.
REITs are good in a rising rate environment for the same reason that private equity real estate is. They have the ability to raise rents to offset any potential increases in borrowing costs. Rising net operating income (NOI) also means higher property values, which can drive capital gains for investors.
Again, the risk of REIT ownership in a rising rate environment is that increasing interest expense can cut into the money available to be distributed to investors.
Idea #4: Direct Real Estate Purchase
A direct real estate investment is one where an individual – or group of individuals – purchases a property on their own.
The benefit of this approach is that investors get to choose exactly which property they want to purchase and they get to reap all of the cash flow produced by the asset. In a rising rate environment, investors/owners have the ability to control the property’s capital allocation decisions and can proactively take steps to mitigate rising rates – like increasing rents.
The downside is that commercial real estate is expensive and investors may have to pour all of their available capital into the down payment on just one or two properties, which limits opportunities for diversification. In addition, rising rates can have a more direct impact on owners’ pockets because they can directly affect the amount of money they can put into their pocket each year.
Idea #5: Value Stocks
A value stock is one that trades at a discount to its fundamentals based on forecasts for future growth and earnings. While they get much less attention from Wall Street than high flier technology names like Amazon or Google, they tend to hold up well in a rising interest rate environment.
According to Damian Handzy, head of research and applied analytics at Investment Metrics, “the more interest rates go up, the more value [stocks] win. Because growth stocks rely on long-term gains, they suffer more from the discounting effect of rising interest rates than value stocks do.” Handzy added that one of his company’s 2021 studies has shown that value stocks would outperform growth stocks by 100 basis points for every 10 percent rise in interest rates.
But, Value Stocks are still publicly traded on equity markets and their past performance is no indication of future valuations. Their share prices can be subject to change based on broader market dynamics like unexpected rate hikes or bad news.
Idea #6: Cash Rich Companies
There are certain companies that produce so much cash that they are able to fund their own growth. Examples of these companies include well known names like Apple, Microsoft, and Berkshire Hathaway.
In a rising interest rate environment, cash rich companies can perform well because they tend to earn more on their cash reserves. In addition, they have the ability to fund their own growth and can use cash for other purposes such as increasing dividends or buying back shares. To put the term “cash rich” in perspective, it helps to look at the balance sheet of a company like Apple who reported nearly $63B in cash on their balance sheet in the third quarter of last year.
The downside of cash rich companies is that they may actually struggle to find profitable uses for their funds. If the funds are deployed into projects that ultimately end up losing money, the share price could be impacted.
Idea #7: Consumer Staple Stocks
Consumer staple stocks are the equity shares of companies that make things that consumers need to buy all the time. Think about things like food, toothpaste, or soap. For example, Procter & Gamble is a classic consumer staple company.
Consumer staples are good in a rising rate environment because consumers need to buy them. And, because consumers need to buy these staples, these companies have great pricing power, which means they can raise prices to offset the impact of rising interest rates.
Again, the downside to consumer staple stocks is that their share price can be impacted by broader market trends that may have nothing to do with the fundamentals of the underlying company.
Idea #8: Gold & Exchange Traded Funds (ETFs)
Gold is a precious metal that derives its value from its scarcity. Exchange traded funds are baskets of stocks that are designed to track a specific index (like the S&P 500 index) or a specific sector like high yield stocks. It should be noted that there are also ETFs, like GLD, which invest in physical gold.
In both cases, the benefit of this asset class is that their prices tend to rise in value during an inflationary environment, especially gold which has long been viewed as an excellent way to hedge against inflation and rising interest rates. In addition, ETFs can provide strong dividend yields and liquidity for their investors because they can be bought and sold at will.
The downside to an investment in physical gold is that it can be difficult to buy and sell and the transaction costs can be high. For ETFs, the downside is that they can also be subject to movements in the broader stock market that can cause prices to decline.
Idea #9: Bond Laddering
Bonds are debt instruments that are issued by governments (like the US Treasury) and corporations. Investors who purchase them are making a loan to the issuing entity and receive their money back in the form of monthly coupon payments plus principal at maturity.
Bonds have different maturities, with short term bonds paying lower interest rates and long term bonds paying higher yields. In a “laddering” strategy, investors purchase investment grade bonds of differing maturities to protect themselves against rising interest rates. Laddering can be done manually, with a financial advisor, or in a specialized bond fund.
Bond laddering is a good strategy for rising interest rates because, when they are held to maturity, investors get their money back, which can then be reinvested into a current bond at a higher rate. Of course, this assumes that the bond issuer is credit worthy and has the resources to repay their debt as agreed.
The potential downside to a laddering strategy is that it is complex and may not be a good fit for beginners. In addition, all of the trades and the construction of the “ladder” can result in high fees. Finally, if rates don’t move or actually fall, the laddering strategy could end up backfiring.
Idea #10: Invest in the Stock of Payroll Processing Companies
There are a number of companies whose core business is to process payroll for other, smaller companies. For example, Paychex and Automatic Data Processing (ADP) are two large, publicly traded data processors.
Payroll Processing companies are good for a rising rate environment because they are usually required to hold large cash balances while waiting to process payroll for their clients. As rates rise, the amount of interest earned on these large cash balances also rises, which can increase profitability.
The potential downside to an investment in a payroll processing company in a rising rate environment is that these stocks can get swept up in broader market trends and may suffer, even if they are earning more interest on their cash balances.
Final Thoughts
Because rising rates increase the cost of capital, they are traditionally a negative for certain types of investments. So, as the economic cycle moves into a period of rising interest rates, investors should proactively take steps to position their portfolio to benefit from rising rates. For example, they should get rid of floating rate debt and lock into fixed rates, to the extent possible. In addition, they should actively invest in companies or assets that benefit from rising interest rates, including: private equity real estate, banks, brokerages, and other dividend paying companies.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
