Rising rates? It may be time to buy, not sell, those REITs

  • REITs are highly sensitive to rising interest rates as their yields start to look relatively less attractive versus fixed-income alternatives.
  • Many question whether REITs suffer with rising interest rates. The answer: Not if it means a strong economy that is helping real estate fundamentals.
  • Investors need to consider the total return picture for the investments rather than just the current yield.

Interest rates are rising. Sell your REITs! That's the usual knee-jerk reaction of investors when the economic cycle is getting old and the Federal Reserve Bank is raising interest rates.

True to form, real estate investment trusts were clobbered in February after the Fed hiked short-term rates again and the 10-year Treasury bond yield spiked to 2.95 percent. The FTSE Nareit All REITs index was down almost 12 percent, although it has since recovered more than half that ground.

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.

Like other high-dividend-paying stocks, REITs are largely sensitive to rising interest rates as their yields start to look relatively less attractive versus fixed-income alternatives. With rates again trending up, it could be a bumpy ride for the REIT market going forward.

It also might be a great opportunity to get into the real estate market.

"If interest rates are going up because the economy is improving, that can be positive for REITs because landlords can raise rents to cover the rate increases," said Brian Cordes, a senior vice president at Cohen & Steers, an investment company focused on real estate. He expects the U.S. economy to grow by 2.9 percent this year. "We see the recent pullback as an attractive entry point to the asset class."

For investors looking for income, the 4.5 percent average yield on the FTSE Nareit All REIT index is an attractive alternative to bond yields. REITs, however, are equities and carry equity risk. Dividend yields are not fixed, and they can and do fall — often dramatically.

Investors need to consider the total return picture for the investments rather than just the current yield, said Cedrik Lachance, director of U.S. REIT research at Green Street Advisors.

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By several measures REITs do look cheap.

The unlevered total return expectation of REITs is currently 5.9 percent versus 4.6 percent yield on 30-year Baa-rated bonds — slightly tighter than the 150-basis-point historical average, according to Lachance. In other words, REITs look slightly overvalued on that front. They are trading 30 basis points lower than high-yield bonds versus an historical average of 60 basis points — suggesting slight undervaluation.

"REITs are not wildly cheap versus corporate bond alternatives, but they are somewhat attractive," said Lachance.

They look better versus the rest of the stock market. REITs posted a respectable 9 percent total return last year, but that significantly underperformed the 21 percent return on the S&P 500 Index (dividends reinvested). Over the last five years, the price/earnings ratio on the Russell 3000 index has expanded from 15.2 to 21.9, while the multiple in the REIT market (based on funds from operations) has fallen from 18.9 to 16.4. "REITs posted similar earnings growth, yet their multiples contracted," said Cordes at Cohen & Steers.

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Brad Case, director of research at the National Association of Real Estate Investment Trusts, sees parallels to the investing environment leading up to the dot-com bust in 2001. "Everyone wanted in on technology stocks, and they sold everything else including REITs," said Case. "The REIT market then outperformed not because real estate did well but because money flowed out of technology and into better-valued stocks."

REITs may look cheapest relative to the underlying value of the real estate they hold. The market historically has traded at a 3 percent to 4 percent average premium over the net asset value of their real estate. They are now trading at an average discount of about 9 percent per data from Green Street Advisors.

Due to the surge in e-commerce, industrial and storage properties trade at about the value of their underlying assets. Malls and shopping centers are trading at double-digit discounts to their NAVs.
Oli Scarff | Getty Images
Due to the surge in e-commerce, industrial and storage properties trade at about the value of their underlying assets. Malls and shopping centers are trading at double-digit discounts to their NAVs.

Certain sectors of the market have performed well. Thanks to the surge in e-commerce and all that free shipping, industrial and storage properties trade at about the value of their underlying assets. Others — notably malls and shopping centers — are trading at double-digit discounts to their NAVs.

These signals, of course, could be a sign not that REITs are undervalued but that the broader stock market is overvalued; that real estate markets, which have significantly surpassed their prefinancial crisis peaks, are overheated.

"The truth is, REITs have better returns when rates are rising. There are no guarantees, but this has been the kind of situation that leads to strong returns in the REIT market." -Brad Case, director of research at the National Association of Real Estate Investment Trusts

The fundamental backdrop for the real estate market, however, is encouraging. Thanks in part to tax reform and fiscal stimulus, most analysts expect a stronger U.S. economy this year and good returns on real estate. What's more, banks have been far more conservative in their real estate lending since the financial crisis, leading to less development and a better supply/demand picture than in previous cycles. Unless a major geopolitical event shatters confidence, or inflation spikes in the rest of the economy leading to a more rapid rise in interest rates, conditions look favorable for real estate.

"This cycle is getting old, but the fundamentals are still good," said Lachance at Green Street Advisors. "Things are much better in industrial and much worse in retail, but we're still seeing inflation like rent increases on average."

Yes, but won't REITs suffer if interest rates are rising? Not if it means a strong economy that is helping real estate fundamentals. When the Fed began raising rates in 2004, the REIT market dove 15 percent but proceeded to rise 78 percent in the face of 17 rate hikes by the Fed over the next three years.

"The truth is, REITs have better returns when rates are rising," said Nareit's Case. "There are no guarantees, but this has been the kind of situation that leads to strong returns in the REIT market."

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