REITs may be running too hot

The drop in interest rates this month has been a boon to real estate investment trusts (REITs), but after an already banner 2014, some are questioning just how high these stocks can fly.

In 2014, all equity REITs produced a 28 percent total return and a 3.56 percent dividend yield at year end, according to the National Association of Real Estate Investment Trusts. In comparison, the S&P 500 produced a 13.69 percent total return with a 2 percent dividend yield.

"REITs have a long track record of providing investors with competitive performance, strong dividend income and portfolio diversification," said the association's CEO Steven Wechsler.

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REIT stocks are attractive to investors who have been searching for yield in this continuing low-interest rate environment. They have been very attractive to global investors especially, as Japan sits in recession, Europe flirts with it, while the U.S. economy accelerates. REITs are up nearly 7 percent just year to date.

By sector, residential REITs were the top performers in 2014 with apartment REITs delivering total returns just shy of 40 percent amid still high demand and rising rents. Health care came in second, but all sectors were winners.

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"If you look at real estate fundamentals: Office, retail, multifamily, industrial, in almost every case fundamentals are accelerating, and that's very exciting," said David Toti, a REIT analyst with Cantor Fitzgerald. "You have a world that's thirsty for yield. Everything is perfect for the REITs right now."

Perfect, perhaps, in the fundamentals, but sky-high valuations are starting to concern Toti, whose firm has a neutral rating on REITs. If interest rates start to rise, REITs suddenly become less attractive, despite their solid fundamentals.

"We could see a repeat in May of 2013 when bond market fell apart," said Toti, noting that REITs are now hitting their historical peaks from 2007. "We are watching interest rates. There is more risk than there is upside."

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On the flip side, REIT fundamentals are so strong, some argue they could withstand a rise in interest rates.

"Yes, it's an interest rate play, but it works because property income is rising," said Dr. Sam Chandan, professor of economics at the Wharton School of the University of Pennsylvania. "Imagine rates are rising, but we still have support from rising incomes. There will be some offset but not a crash."

Investors will, however, have to be more discriminating about specific REIT sectors, as some are seeing better income than others. Apartment gains are likely to moderate, as much more supply comes to major markets. Office, however, could see more gains.

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"The REIT's capacity to sustain income growth becomes significantly more important," added Chandan.

REIT EXPLAINER: While REITs are required by law to pass on 90 percent of their taxable earnings to shareholders, most pass on 100 percent in order to remain competitive in the market, so they are not taxed on the remaining 10 percent. That is why their dividends are consistently higher than those in the S&P 500. Historically, the REIT dividend is about 60 percent of the total return, while price appreciation accounts for 40 percent.