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December 3, 2016

REITS and Rates: The Investor Landscape

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REITS and Rates: The Investor Landscape

Analysts say that while real estate investment trusts may suffer in the short term due to the Fed’s plans to raise interest rates, the decline may offer an attractive buying opportunity.

Most economists and money-market traders expect the Federal Reserve to begin boosting rates in December. The central bank has kept the federal funds rate at a record low of zero to 0.25 percent since December 2008. But even if the rates don’t increase until next year, real estate professionals may be wondering what the eventual effect will be on real estate investment trusts.

“In the short term, there’s no question that Fed rate hikes aren’t good for REITs,” says Barry Vinocur, editor of REIT Zone Publications in Novato, Calif. However, with Fed officials having said that they won’t move on rates until they feel confident the economy is indeed strengthening, Vinocur says a more optimistic view is also emerging: “If rates are going up because the economy is doing well, a stronger economy is good for real estate. So whatever happens in the short term, in the long term, this is good for REITs, the argument goes.”

But Vinocur himself is not necessarily convinced Fed rate hikes will help REITs in the long term. “The argument is that in the past when rates were raised, REITs have done well, but this is a different situation in the economy now,” he says. “We’re in the late stages of a recovery from the 2008 to 2009 meltdown, and globally there are question marks on economies around the world.”

Robert Gadsden, a portfolio manager for the Alpine Realty Income & Growth Fund based in Purchase, N.Y., says the issue is what’s causing the rate hikes. “It’s because the economy is getting stronger, and there are higher inflation expectations,” he says. “Higher GDP growth is good for real estate fundamentals. Landlords can get higher rents from their tenants.”

The MSCI US REIT Index, a free float-adjusted market capitalization index comprised of equity REITs, has dropped 4.3 percent so far this year. When the Fed last raised rates—between 2004 and 2006—the index slid 1 percent in the first 26 days, but rebounded for a rise of 32 percent in the first year.

Over the entire period from 2004 to 2006, which saw the Fed funds rate climb to 5.25 percent from 1 percent, the index returned 59 percent, compared to 15.5 percent for the S&P 500. However, Gadsden, echoing Vinocur, says the prior period of Fed tightening is “worth looking at, but there isn’t any perfect mirror to where we are now.”

Certainly the low-rate environment of the last seven years has been favorable for REITs. Slow and steady economic growth has prevented overdevelopment, especially in the commercial space, says Robert Goldsborough, a fund analyst for Morningstar, an investment research firm in Chicago. “Tenants are going to existing properties. That’s great news for landlords and REITs. At low interest rates, property owners can easily refinance their debt too.”

However, as the Fed raises rates, REITs’ interest payments rise as well, he points out. “That means [fewer] dividends unless you’re able to raise rental rates enough to offset” the increased interest payments, Goldsborough says. But the likely slump for REITs could represent a decent entry point for investing in REITs with short lease durations, which can raise rents quickly. That includes multifamily, self-storage, and industrial REITs, he says.

Rising short-term rates won’t have a major impact on REITs’ balance sheets, because most of their debt is long-term at fixed rates, Gadsden says. “Sentiment is shifting, but the question is what happens to long-term rates.” Many analysts expect long-term rates to stay steady, as inflation remains minuscule and the Fed has pledged to keep its rate increases slow and shallow.

“If higher rates happen slowly, then I think REITs can continue to grow earnings and dividends,” Gadsden says, adding that REIT prices remain attractive. “REITs are trading at a discount to breakup value.”

Others agree that REITs are a solid long-term investment. Vinocur notes that the MSCI US REIT Index has, on average, outperformed the S&P 500 over the past 20 years. “I believe REITs are a good investment in a balanced portfolio,” he says. “Asset allocation people say REITS should make up 10 to 15 percent of your portfolio.”

Vinocur recommends sticking to blue-chip REITs, such as Boston Properties, an office REIT; Simon Property Group, a shopping-center REIT; and Essex Property Trust, an apartment REIT. “They have performed well over cycles,” he points out. Boston Properties has generated an annualized return of 8.5 percent over the past 10 years, Simon Property has returned 12.32 percent, and Essex Property has returned 11.2 percent over the same time period.

To gain a diversified real estate portfolio, you might want to consider a mutual fund or exchange-traded fund composed of REITs. Vinocur and Goldsborough both suggest Vanguard REIT ETF. “It gives you an incredibly low-cost, broad-based exposure to REITs,” Goldsborough says. The fund’s expense ratio is a mere 0.12 percent. Keep in mind that these are suggestions for consideration, not recommendation. As with all investments, you should thoroughly research any REIT, mutual fund, or ETF before putting your hard-earned money into it.

But regardless of what investment vehicle you use, now may be a good time to take advantage of short-term pain for long-term gain by investing in REITs, assuming analysts’ predictions about the effect of rate increases by the Fed are correct. 

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