Real estate investment trusts, or REITs, do fine when the real estate market is strong, but are threatened when rising interest rates undermine the value of interest earnings. At least, that’s the common wisdom.
Last week, the Federal Reserve raised short-term interest rates for the second time this year, and indicated it will raise rates two more times by year’s end, and perhaps twice in 2019. What’s that going to do to REIT values? Are REITs a good bet in times like these, or not?
Despite the common worry about rising rates undermining fixed-income investments, REITs have actually done well during these periods, says Robert Johnson, principal at Fed Policy Investment Research Group in Charlottesville, Virginia, and former president of the American College of Financial Services. Johnson and two co-authors studied REIT performance for their book “Invest with the Fed.”
[See: 6 REIT Funds to Buy With Robust Dividends.]
REIT performance has been nothing to brag about this year. The FTSE Nareit All Equity REITs index, a gauge of property-owning REITs, shows annual dividends averaging 4.12 percent at the end of May. While that beats many fixed-income investments, those REITs had lost 2.79 percent since the start of the year, as dipping share prices wiped out dividend earnings. Over the past 10 years, annual returns have averaged 6.62 percent, not much to show for the kind of risk real estate investments entail.
REITs are like mutual funds, using professional managers to invest funds from ordinary investors and institutions. But instead of buying stocks and bonds, REITs own real estate like apartment buildings, office buildings or malls. A REIT must pass at least 90 percent of taxable income to investors via dividends to avoid taxation at the company level. Investors value REITs for generous dividend payments and can also enjoy capital gains if the REIT’s properties grow in value.
But things can go wrong. Any number of factors, from bad REIT or property management to broad economic conditions to the failure of a big local employer to violent weather, can torpedo property values, undermining the REIT’s share price. The yield on the dividend — annual interest earnings divided by the REIT share price — can become less attractive if rising interest rates make other investments more generous. That can drive down the REIT’s price.
That seems to make this current period of rising interest rates look hazardous. But Melissa Reagen, head of research for the Americas at TH Real Estate, an international real estate management firm, says commercial real estate can weather these conditions if the rate increase is slow.
“If interest rates are rising because of stronger economic growth, as is currently the case, real estate demand will also likely be growing,” she says in a report published by her firm’s parent Nuveen, the investment management company. “If interest rates are increasing gradually, and are likely to remain at, or below, long-term averages, as is currently expected, real estate would likely be well positioned to benefit in such an environment.”
She says that property values grew in a majority of periods since 1987 when the yield on the 10-year Treasury note increased by one percentage point or more.
Scott Crowe, chief investment strategist at CenterSquare Investment Management, a global investment manager focused on actively managed real estate and infrastructure, says REITs should be profitable in the near future but indicates investors should not get hopes too high.
“Historically, REITs have delivered mid-single digit positive returns during periods of rising long-term interest rates, Crowe says. “Rates rise because growth improves and increases [net operating income], which more than offsets valuation pressure from higher rates.”
Borrowing costs for REITs do not necessarily rise in lockstep with other rates because “lenders become more optimistic,” he adds. And he says the less-than-thrilling REIT performance of recent years presents a buying opportunity today.
“REITs have only been this cheap versus equities twice before over the last 20-plus years — [during the] tech boom and the global financial crisis. At those previous points, not only have REITs delivered positive returns but also outperformed equities.”
[See: The 10 Best REIT ETFs on the Market.]
Sean Hanlon, CEO at Hanlon Investment Management in Egg Harbor Township, New Jersey, says that rates are rising now because the economy is doing well.
“A strong economy can boost operating income for REITs, and REITs are well-suited for inflationary environments since they represent ownership in a physical asset,” Hanlon says.
REITs tend to take out long-term loans, so many will benefit from the low borrowing rates they have locked in over the past few years, he says.
Who is the ideal REIT investor? Crowe says they are good for investors who want to buy into commercial real estate but cannot purchase properties directly. That includes those who simply cannot afford an entire building and those who want the ability to get in and out at will, since a REIT trade can be done with a few mouse clicks.
REITs are also good for income-oriented investors and those who want to diversify portfolios already containing standard investments, since real estate marches to its own drummer, he says.
“Over time, REITs have delivered about two thirds of their return from income and one third from capital appreciation,” Crowe says. “For older investors the REIT income is attractive, and for younger investors, REITs give them exposure when they tend to be under-allocated to real estate.”
Hanlon says REITs offer young investors a hedge against inflation. That’s because inflation drives up property values, making REIT assets more valuable.
Since REIT dividends are taxed as ordinary income, young people investing for the long term are better off owing REITs in Roth accounts, he says. Roths do not tax annual income if it is not withdrawn, so the young investor can reinvest dividends to compound growth over the decades.
Still, investors should prepare for a sometimes wild ride, Hanlon says.
[See: 7 REITs to Buy for Regular Income.]
“REITs can be volatile at times, so it is important for older investors and retirees to understand this, and utilize REITs alongside more stable fixed income asset classes,” he says.
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REITs Can Cope With Rising Rates originally appeared on usnews.com
