Rates hit REITs: Should you dump them?

Red hot REITS
Red hot REITS   

They were the stocks to buy in a low interest rate environment, their enticingly high dividends exactly what yield-hungry investors were hunting for. Now the stocks of real estate investment trusts (REITs) are taking a dive on fears of higher interest rates.

The S&P REIT index is down close to 8 percent in the last month, and almost 3 percent since Monday, as interest rates climbed.

"There is a natural reaction that occurs when rates go up that you sell interest rate sensitive names. It's natural, but people have to step back and say, 'Where do I think interest rates are really going to go?'" said Alexander Goldfarb, a REIT analyst at Sandler O'Neill.

Traders work on the floor of the New York Stock Exchange.
Brendan McDermid | Reuters
Traders work on the floor of the New York Stock Exchange.

REIT fundamentals are still very strong, as the commercial real estate recovery rallies more decidedly than residential housing. Vacancies in multifamily are near historic lows, and rents continue to soar. Office vacancies are also declining, as the economy adds more jobs. Industrial REITs are benefiting from strong warehouse demand, and retail, while the laggard, is also seeing some improvement along with the wider economy.

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Commercial property values are also soaring, as supply is not keeping up with general demand. Commercial property prices are up 15 percent since the August 2007 peak and up 11 percent in the past year, according to Green Street Advisors, a real estate analytics firm. Self-storage, lodging and multifamily apartment values are leading the gains.

REITs still offer the potential for very attractive returns compared to the broader markets, when you factor in dividends and when the knee-jerk reaction to rates quiets. The total return of the full, stock exchange-listed U.S. REIT market, as well as the total return of U.S. equity REITs, was four times the total return of the S&P 500 in the first quarter of 2015, according to the National Association of Real Estate Investment Trusts.

This was before the rise in interest rates, but REIT dividends are also higher than the S&P. Again, it's fundamentals.

"Today, you're earning more from the buildings than it costs you to finance them. You don't need any rent growth. That's what gets investors upper single-digit returns," said Goldfarb.

That is also why we're seeing a new wave of REIT privatizations. Fitch Ratings issued a report this week entitled "The Privatization Fuse is Lit," pointing to recently announced acquisitions of Excel Trust and Associated Estates.

The Fitch report said: The last meaningful period of REIT privatizations occurred between 2005 and 2007, when 30 REITs were acquired representing $123 billion of enterprise value. Current market conditions are setting the stage for another round of acquisitions, potentially of a similar magnitude. If the last wave is any barometer, REIT public-to-private transactions could number 30 to 40 in the next few years.

As large investors like sovereign wealth funds and pension funds look to REITs, they offer a more favorable yield than anything in the bond market. By taking the REITs private, they have a tangible asset that they can see, visit and at the same time earn upward of 9 percent returns.

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"Debt and equity capital are in ample supply, low cost and less discerning," said Britton Costa, a director at Fitch. "Since REITs do not need to trade as wide of a discount or have as much growth for returns to pencil out in a low-yield world, the number of candidates increases; more capital and more targets should mean more transactions."

Investors may continue to dump REIT stocks on fears of higher interest rates in the short term, but even with a slight move higher, rates are still comparatively low. Fundamentals point to still-solid REIT returns and a healthy commercial real estate market.