Is the party over for REITs?

In the barren yield landscape of the last five years, real estate investment trusts have been one of investors' favorite places to find income. The MSCI U.S. REIT Index, which has a current yield of just under 4 percent, was up 30 percent last year. It has returned an average of more than 12 percent over the last five years — with close to half of that paid out in cash dividends to investors.

This year is a different story. With volatility returning to the stock market as it waits for the Federal Reserve to raise interest rates, the party could be over for REIT investors.

"The big challenge this year for REITs has been the uncertainty over interest rates," said Keven Lindemann, director of real estate for S&P Capital IQ. "The fundamentals for most property types are still good, but share prices are getting hit by concern over higher rates."

From its peak of 1,230 in late January, the MSCI REIT Index fell nearly 20 percent before staging a rally with the rest of the stock market in October. It was down sharply and up again through November, trading at 1,085 on Dec. 2. The seesaw will likely continue until there is more clarity about economic growth and the speed of Fed rate policy change.

"All year long there's been a flip-flop going on between expectations for economic growth and interest rates," said Joseph Smith, chief investment officer for CBRE Clarion Securities, which manages about $22 billion in real estate assets. "That uncertainty creates volatility, and in times of volatility, the correlation of REITs with the broader stock market increases."

REITs, which are required to distribute 90 percent of their income as dividends, are sensitive to rising interest rates for two major reasons. First, real estate is a capital intensive business. When rates rise, eventually the interest expenses for REITs will, too, and that in turn could reduce the amount of income available for distributions to investors.

Second, REITs are popular with investors because of their high dividend payouts. As interest rates rise, not only could the payout ultimately suffer but REITs will become relatively less attractive than other fixed-income investments sporting higher yields.

Both Smith and Lindemann, however, think that REITs could still hold up well even if the Fed does start raising rates soon. For one thing, the median yield on the 241 REITs that S&P Capital IQ tracks in the U.S. and Canada is currently 4.7 percent — more than twice the yield on the 10-year Treasury bond.

Most market observers also expect that the rate-raising cycle could be short-lived given the uncertain economy and the fact that other central banks around the world are loosening monetary policy. What's more, debt maturing for REITs now is typically paying higher interest than prevailing market rates — meaning, interest expenses could continue to fall for some time.

"If there's clarity on economic growth and the pace of rates rising is consistent, I think real estate stocks can continue to do well," Smith said. The biggest reason for his optimism is the strong fundamentals underlying virtually every sector of the real estate market.

Unlike with other recessions, construction and real estate development has been very slow coming out of the financial crisis. While the economy has not been strong, occupancy and lease rate trends continue to improve for virtually all corners of the real estate industry.

"The economy has been slow to recover," Smith said. "A silver lining to the financial crisis for real estate is the lack of supply in most sectors of the market.

"The only area we're worried about in terms of supply and overbuilding is the assisted-living sector," he added.

Apartments, office developments, industrial properties and a wide range of other segments in the real estate market are enjoying good underlying supply/demand conditions. The REIT industry as a whole has also managed their balance sheets more conservatively than other cycles, said Lindemann of S&P Capital IQ.

Interest rates rising will have negatives effects on REITs in the long run, but the operating results and distributions of REITs will likely continue to improve through next year regardless of what the Fed does.

So far this year, 120 of the 241 REITs that Lindemann follows have raised their dividends for 2015, and many more are likely to do so before year-end. "Companies have a high degree of confidence in their operations and visibility into the cash they're generating," he said.

With a projected increase of 7 percent in funds from operations next year, Lindemann expects the average dividend payout to stay in the range of 4.5 percent to 5 percent.

He also thinks that the average discount of 12 percent to net asset values that the nearly $1 trillion universe of North American REITs currently trade at will provide some support to share prices if things go sour.

The biggest risk for REIT investors is a recession. If the slowdown in global growth results in a recession here, the stock market is going to go down — and so will REITs. If the more likely scenario of continued slow growth and modest rises in interest rates plays out next year, however, the recent dip in REIT prices could be a buying opportunity.

"From a property fundamentals perspective, this is a great market, and REITs, which tend to own very high-quality assets, are in a very good position," Lindemann said. "If investors have a three- to five-year time horizon, this could still be a good time to get into the REIT market."

— By Andrew Osterland, special to CNBC.com