Rising Rates Hit REITs Hard

Craig McCausland | E+ | Getty Images

Several years of rock-bottom interest rates, fueled by the federal government, have had investors in a desperate search for yield. That was a plus for real estate investment trusts (REITs), which are required to pay 90 percent of their profits out in the form of dividends to investors. The minute rates began to rise, suddenly the darlings became the duds.

At an annual industry conference in Chicago this week, rising interest rates are front and center. Representatives of more than a hundred REITs are questioning how they will have to change their strategies should rates suddenly soar.

"REITs are highly sensitive to the interest rate environment, they're effectively bond substitutes on the equity side. They are enormous users of capital," says David Toti, a REIT analyst at Cantor Fitzgerald. "A change in rates impacts their cost of capital, and it impacts their ability to acquire aggressively."

(Read More: Reverse Mortgages Backfiring on Seniors)

After rising steadily through much of 2012, the Morgan Stanley U.S. REIT index is down nearly 8 percent since the middle of May. REITs underperformed the broader markets in May after beating them handily in April. That is largely because investors were rushing into the stock market.

"The issue with rising rates is that yield-sensitive products become less attractive potentially as investors move from bonds to stocks. REITs get caught in the downdraft," says Toti, who warns that the office and industrial sectors will be hit hardest by rising rates.

Multi-family REITs, which have been underperforming their peers of late, could actually see a benefit to rising rates, if they are really indicative of a brighter economic outlook.

"We have short dated leases, and as we see an improving economy and jobs, that's just going to bring more people into our apartments," says David Neithercut, CEO of Equity Residential, the nation's largest multi-family REIT.

(Read More: Home Prices Jump to Seven Year High)

Investors have been shunning multi-family REITs lately, pointing to an improving housing market and worried that a wealth of new apartment supply is in the pipeline. Multi-family housing starts have jumped dramatically, with the number of units currently under construction in April up 11 percent from a year ago, according to the U.S. Census.

"Rising interest rates and increasing cost of new supply will help keep that supply down and will allow us to continue to increase rates on our existing residents," says Neithercut.

A subset of multi-family, the lesser-watched student housing sector, could also benefit, specifically the largest, American Campus Communities (ACC). Since it has so little competition, it benefits from a cheaper cost of capital.

(Read More: Map: Tracking the US Real Estate Recovery)

"We actually have a very favorable comparison in terms of yields. The development transactions that we're undertaking typically are 7 to 7.25 yield, a nice spread to multi-family, so we tend to have more cushion in that regard," says Bill Bayless, CEO of American Campus.

For the overall REIT space, however, analysts are questioning whether this is a long term cyclical change tied to improving gross domestic product. If so, sectors with shorter-term leases, like multi-family, self-storage and health care may fare better than office or industrial, which have longer-term leases.

—By CNBC's Diana Olick. Follow her on Twitter @Diana_Olick or on Facebook at facebook.com/DianaOlickCNBC.

Questions? Comments? [e-mail]

Correction: This version corrected that REITs are required to pay 90 percent of their profits in the form of dividends to investors.