Rising interest rates make the cost of financing property more expensive, something that real estate investment trusts understand all too well. Still, if you’re thinking of evicting REITs from your portfolio ahead of future rate hikes, there’s more to the performance of these investments than higher interest rates might suggest.
“The relationship between interest rates and REITs might scare some investors off,” says Nick Vertucci, founder and CEO of Nick Vertucci Real Estate Academy in Irvine, California. “REITs can be more sensitive to interest rates because they have a higher dividend yield.”
In fact, “REITs are 47 percent correlated with interest rates, with only regulated utilities having a higher correlation,” says Jay Hatfield, portfolio manager of InfraCap REIT Preferred exchange-traded fund (ticker: PFFR).
[See: The 10 Best REIT ETFs on the Market.]
And rates are rising. The Federal Reserve has increased the federal funds rate six times since December 2015. The forecast for 2018 calls for three to four additional rate hikes, with the potential for three more in 2019.
Over the last decade, there were three periods that demonstrated sharp negative relationships between REITs and interest rates. But over the long haul REIT cash flows can improve if the rate hikes reflect a booming economy, Vertucci says. As for recent performance, REITs have lagged the market, with a 2.7 percent total return over the last 12 months compared to the S&P 500’s 14.8 percent, Hatfield says.
Past performance, though, is no indication of future returns, and with REITs, it’s worth looking at the bigger picture.
The choice of sector matters. Some REIT sectors fare better than others when interest rates rise. Robert R. Johnson, principal at the Fed Policy Investment Research Group in Charlottesville, Virginia, has studied extensively how REITs in different sectors perform as rates fluctuate. When rates increase, equity REITs tend to rise to the occasion while other REIT sectors lag.
“From 1972 to 2013, mortgage REITs had a negative return during rising-rate environments,” losing 4.1 percent annually, Johnson says. Over that same period, “equity REITs returned 9.8 percent in rising-rate environments.” Composite REITs returned 5.1 percent when rates rose.
The obvious choice is to steer away from mortgage REITs as rates rise, but how do you choose which equity REITs to pursue? Here, too, the answer lies with the sector the REIT is in.
“Some argue interest rate increases are a good thing for office and residential REITs because of the correlation with economic growth and increased demand,” says Brian Mirau, founder and president of Mirau Capital Management in Ruidoso, New Mexico. But “investors need to make sure returns are on track with the forecast.”
[See: 7 REITs to Buy for Regular Income.]
Rising rates can be indirectly positive for some REITs, says Ray Sturm, co-founder and CEO of AlphaFlow, an asset manager specializing in real estate loans. If occupancy levels and rents are also rising along with rates, “that could offset the downside of increased borrowing costs so some REITs could perform well.”
Hatfield says REITs with higher exposure to economic growth and e-commerce are worth considering. “Industrial REITs are benefiting from the growth of e-commerce, and data center REITs are benefiting from the growth of cloud computing and are likely to continue to outperform.”
You may be looking at the wrong rate. While REITs can be affected by changes to the federal funds rate, it’s the 10-year U.S. Treasury rate that matters most, says Rob Stevenson, managing director and head of real estate equity research at Janney Montgomery Scott in New York.
“When you do want to avoid REITs and where they almost always underperform is when the 10-year Treasury experiences hard, fast and unexpected upward movements,” Stevenson says.
Treasury yields are influenced by economic growth and inflation. When the economy is strong and inflation is expected to rise, the price of longer-term Treasury bonds can fall, triggering higher rates. REITs took a hit in February after the Fed raised short-term rates and the 10-year Treasury yield reached 2.94 percent. The 10-year Treasury yield hit 3.12 percent in mid-May and continues to hover near the 3 percent mark.
Sturm says further rate hikes will only increase the headwinds REITs face with growth, and the big question is whether their fundamentals can improve at a rate that outpaces rising rates. Diversifying with shorter-term real estate investments, such as real estate crowdfunding, could help hedge your bets if you’re concerned about reducing interest rate exposure.
Your own financial picture plays a role. Rising rates should be viewed in the context of your broader financial plan and investing horizon.
If you’re on the verge of retiring, for example, pulling away from REITs could reduce risk because they’re more volatile compared to other fixed-income investments. “If you’re using REITs for income and diversification and that fits your age and risk tolerance, you should be prepared for changing values,” Mirau says.
On the other hand, consider what you may be giving up by selling when REIT yields are increasing. “Often, stories pound the drum that you don’t want to own yield or dividend-paying stocks in rising-rate environments, but for those that need income, this argument doesn’t hold,” Stevenson says.
He says investors should remember that historically a huge chunk of the market’s total return has come from dividends, not stock price appreciation. According to Morningstar data, 82 percent of the S&P 500’s total return since 1960 can be attributed to dividends and the power of compounding interest. That’s a strong incentive for sticking with REITs, specifically those sectors that are positioned to do well when rates rise.
[See: 8 REIT Categories With the Wind at Their Backs.]
Investors must also keep in mind the potential pace of future rate hikes. “If future rate hikes are gradual, our economy will likely continue its growth,” Mirau says. Overall, the outlook for REITs remains positive, but “it should be watched closely.”
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What Higher Interest Rates Mean for REITs originally appeared on usnews.com
