Real estate investment trusts saw strong gains so far in 2016, outperforming the broader Standard & Poor’s 500 index, but whether REITs can retain those strong gains is in question.
According to the National Association of Real Estate Investment Trusts, an advocacy group for the industry, the total return of the FTSE/NAREIT All REIT index was 12.6 percent through Sept. 30, while the S&P 500 posted a total return of 7.8 percent. The yield on the 10-year Treasury note dropped 0.7 percent in the first nine months of 2016.
Such strong returns may be difficult to reproduce in 2017, especially if the Federal Reserve raises interest rates in December as many debt-market analysts expect.
Given the environment for REITs may change, investors may need to review their holdings depending on their view of Fed action, real-estate market watchers say.
[See: The 10 Best REIT ETFs on the Market.]
Yields make REITS attractive. REITs offer attractive yields for investors who need income, especially in light of the very low yields offered by the U.S. Treasury market. The benchmark 10-year U.S. Treasury note is hovering around 1.75 percent.
“REITs are and have been a tremendous source of excessive yield,” said Jamie Anderson, managing partner of Tierra Partners based outside of Philadelphia, which runs the Tierra XP Latin American Real Estate ETF (ticker: LARE). “This has driven REITs to where they are trading at historically high valuation.”
John Snowden, global portfolio manager at Resource Real Estate in Philadelphia, agrees. “REITs have had a fantastic run. Anyone who invested in the sector six or 12 months ago should be very pleased,” he says. “Clearly that level of return isn’t likely going forward, but I don’t think it’s time to exit the sector.”
U.S. REITs have pulled money from other countries, says Ken Leon, industry analyst at S&P Global Market Intelligence in New York. Sovereign wealth funds from the Mideast and China are investing in them, as are institutions such as insurance companies in countries that are dealing with negative interest rates and need to match long-term investment returns with their liabilities.
But there are signs that investors are becoming more hesitant.
“The recent inflow of capital into the REITs as investors looked for higher-yielding stocks appears to have reversed somewhat as an interest rate increase now appears more imminent,” according to an October research note from Baird equity research.
Higher rates not the whole story. Yet Leon says investors need to remember that rising rates alone aren’t a risk to the fundamental outlook for real estate and REITs.
“They are impacted by the magnitude of rising rates,” Leon says. “It is true that when there is a rate hike the short-term rates go up a bit — the REITs are perceived as interest-rate sensitive — so they will pull back a little, but I think that’s more temporary. It’s the economy that really drives the underlying performance of REITS.”
Even so, Leon says, it’s possible that REITs’ stock performance could be lackluster in 2017.
Drew Babin, senior research analyst for Baird in Philadelphia, says when it comes to REIT investors’ holdings, they should take into consideration their views on what the Fed might do. He says interest-rate increases by the Fed rarely affect the 10-year U.S. Treasury note, and adds REITs rose when the Fed hiked in December 2015.
That said, investors may want to watch how interest rate markets handle a rate increase.
[See: 20 Awesome Dividend Stocks for Guaranteed Income.]
“If interest rates are rising for the right reason, that there’s growth in the underlying economy, you want to be in sectors that have shorter lease terms. You want to own hotels, self-storage, apartment sectors, (places) where the landlords can take advantage of the rate hike. But if we have a rate hike and (the 10-year Treasury) goes back down to 1.5 percent, you’ll want to own REITs with longer leases like health care sectors, where they have that stability,” Babin says.
One area that is seeing strong demand are warehouse REITs. “There’s a phenomenal renaissance from the industrial side with the proliferation of e-commerce and adding (distribution) centers closer to urban areas. It’s huge,” Snowden says.
Snowden says in the industrial side their firm holds STAG Industrial (STAG).
Leon also says with unemployment dropping, equity REITs might do well. Those REITs are focused on offices, and Leon says buildings located in central business districts are “very good,” while suburban-based offices are stable but not as good as in central districts. In this sector Snowden says his firm owns City Office (CIO).
Data center REITs may also offer some growth, they said.
“Data center REITs are going up because of the move for more IT and cloud technology. The need for data storage is ever-greater,” he says. “We like Communication Sales & Leasing (CSAL), which is up 60 percent this year. We think it will continue to perform in 2017.”
One area that isn’t doing well are apartment REITs, Babin says. After years of tight housing supply and rising rents, more apartments are coming on the market, so rents are likely to soften.
[Read: How to Invest in Real Estate Through REITS.]
“I don’t see apartment fundamentals (improving) because of new supply coming on,” Babin says.
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Can REITs Survive an Interest Rate Hike? originally appeared on usnews.com
