A portfolio diversifier for a rising rate environment

  • REITs do better in rising rate conditions because they thrive under the very same economic conditions that prompt the rate raise.
  • During the 2004–2006 rate raises, REITs posted cumulative total returns of 77.9 percent.
  • REITs exhibit low volatility in general but do go through their own choppy periods.

Investors seeking portfolio diversification and income as the Federal Reserve approved its second interest-rate hike of 2017 should be aware of the rate-hike-resistant history of real estate investment trusts.

As financial markets had anticipated, the policy-making Federal Open Market Committee increased its benchmark target a quarter point. The new range will be 1 percent to 1.25 percent for a rate that currently is 0.91 percent. This is the third time in the past six months that the Fed has followed through with an interest-rate hike.

REITs, investments in the equity of companies with real estate holdings and — in many cases — traded on major exchanges, have historically performed well in rising rate environments. Actually, they've usually done better during periods of rising rather than declining rates because the same improvements in macroeconomic conditions that prompt rate increases also lead to improved REIT performance.

Real estate investment trusts have historically performed well in rising rate environments.
Hendra Su | Getty Images
Real estate investment trusts have historically performed well in rising rate environments.

During the 2004–2006 period of Fed rate increases, for example, REITs posted cumulative total returns of 77.9 percent, compared with 32.5 percent for stocks and 8.6 percent for bonds.

REITs own a broad array of property-ownership ventures, including apartments, hospitals, warehouses and commercial property such as hotels, shopping malls and office buildings. The game for direct investors is to assess shifting demand variables for these specific markets. These shifts are of less concern to long-term investors seeking exposure through actively managed mutual funds and passively managed index and exchange-traded funds. (Some REIT ETFS are actively managed.)

This is a small market, totaling only about $900 billion — not much greater than the market cap of Apple — and consists of only about 220 distinct property-owning entities.

Most REITs' income is from lease payments on property they own, so they generally have good cash flows to fuel earnings and dividends. Long-term, annual dividend yields have hovered around 4 percent.

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Historically, REIT performance on average has not been correlated with that of the stock (or bond) market. But during some periods, it has. Between 1988 and 2015, REITs and the stock market both returned about 12 percent annually.

As a result of the dot-com boom, stocks outperformed REITs in the late 1990s, returning between 12 percent and 18 percent annually, compared with REITs' 9 percent to 15 percent. But since 2001, REITs have beaten stocks by 3 percent to 5 percent annually.

Though REITs have exhibited fairly low volatility in recent years, they occasionally go through distinctly choppy periods. The Dow Jones Wilshire REIT Index lost more than half its value in 2007–2008.

A key factor driving REIT performance in recent years has been the demand for residential, industrial and office space. Pent up since the financial crisis of 2008, this demand has been driving strong construction in all of these categories since 2015 and currently shows few, if any, signs of abating.

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In the housing market, increasing wage and consumer confidence are intensifying this demand among consumers seeking 1.5 million new households of all types per year. The category is benefiting from an improving job market that allows kids to finally move out of their parents' homes, and from seniors seeking to downsize.

While residential REITs are still performing well, this category isn't among the top few performers. Currently, the fastest-growing categories are industrial space (including warehouses benefiting from the "Amazon effect" — the proliferation of online order fulfillment centers), data centers and office space, which grew 13 percent in 2016.

Among the poorest-performing REIT categories are those that own brick-and-mortar shopping centers, which have been losing business to said Amazon effect. While Macy's and Nordstrom may not need as much retail space, their online businesses, like those of strictly online retailers, are all about mega-warehouses.

Contrary to stock funds, REIT funds are creatures of millions, instead of billions, of dollars. The fund market is dominated by Vanguard, whose Vanguard REIT ETF (which currently owns about 160 REITs) is the largest, with only about $62 billion in assets in recent weeks. The other three funds in the top four all recently have totaled less than $10 billion. Recently, all four have had significantly overlapping holdings and all — particularly Simon Property Group, which owns shopping malls — have concentrations in retail REITs. Investors seeking to avoid retail exposure have little choice but to seek active management. But this shouldn't be a deal breaker for passive-management aficionados.

"In this small universe of potential holdings, the key to good returns for active managers isn't security selection but the timely weighting of select groups based on economic analysis."

In another reality reversal from the stock market, active REIT managers have over the past decade outperformed their benchmarks more often than not, and have done so twice as often as stock fund managers. In this small universe of potential holdings, the key to good returns for active managers isn't security selection but the timely weighting of select groups based on economic analysis. For example: What are the relative strengths of the near-term market for timber versus data centers?

Investors can evaluate active managers the same way they do for general equity mutual funds, with one key difference: There are so few — only 58 companies manage REIT funds — that investors can evaluate all of them.

As a practical matter, the Lilliputian nature of the REIT market relegates the product to a minor role, even in small portfolios. Professionals can't buy gobs of them incrementally without pushing up the price for their next purchase. And the best tack for most individual investors is to add REITs to their portfolios to serve as a tincture of alternative-asset diversification for the long term.

— By Dave Gilreath, partner and founder of Sheaff Brock Investment Advisors

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