As the economy revs up, so does talk of an interest rate hike. For advisors cobbling together a retirement portfolio for their clients, the question becomes: How will the different investment classes perform in a rising interest rate environment? For publicly traded real estate investment trusts (REITs), rising interest rates typically foster mixed results. Yet, according to the experts, REITs remain a vital part of retirement investment holdings because of their ability to diversify and stabilize a portfolio.

Quarterly statistics from the National Association of Real Estate Investment Trusts (NAREIT) indicate the sector has slumped in recent months. In the second quarter (as of June 29), total returns (the share price movement plus dividends paid) for the FTSE NAREIT All Equity REITs index slid down 9.17% (even though they were up 3.98% in Q1). That drop was due mostly to REIT stock price returns, which declined 10.03%; dividend yields, meanwhile, rose 3.88%. Likewise, Morningstar had charted a 3.11% dip in U.S. open-end real estate fund returns for the year by the end of June.

A May report from Lipper further documents investors’ retreat from the class. Net redemptions from equity real estate funds stood at $852 million, one of the largest drops in the equity funds sector. Real estate as a subsector didn’t fare much better on the equity ETF side. There, real estate ETFs amassed nearly $1.1 billion in net redemptions.

When talk of rising interest rates swirls, investors tend to exit REITs, confirms Brad Case, NAREIT’s senior vice president of research and industry information. Yet he asserts investors may be mistaken in the belief that an interest rate hike portends a significant negative impact on the REIT sector. “That was the pattern we saw in 2013, when REITs fell in May with the Fed’s announcement it would consider raising rates,” Case recalls. “But [the sector] recovered by year-end and went on to deliver a 28% gain in 2014.”

Even if the Fed hikes rates, Scott Crowe, global portfolio manager for Resource Real Estate, does not foresee the 10-year Treasury rate shooting up to 3% or 4%. He oversees a global publicly traded REIT fund and an income fund that invests in both public and private real estate assets.

In the near term, Crowe says investors in commercial real estate can seize some fairly attractive yield spreads over other asset classes. He estimates the global average yield for the sector rests around 3.5%. “That is low by historical standards,” he says, “but every yield is low by historical standards.” By comparison, yields for 10-year bonds and equities hover around 2%, he notes.

Crowe emphasizes REITs are more than just a dividend yield play. REITs retain approximately 40% of their cash flow, which enables them to reinvest in their properties and acquire new assets. By doing so, REITs provide investors with a growth story.

 

How Will Higher Interest Rates Impact REITs?
If the Fed hikes rates, REITs will be wounded. Higher interest rates boost borrowing costs, which, in turn constrain REITs’ ability to obtain reasonably priced capital to acquire new properties and therefore expand.

Although most experts agree REITs are fairly priced now, they could take a short-term hit if rates rise and investors rapidly exit the sector. Chris Cook, president of Beacon Capital Management, a third-party portfolio manager, asserts that REITs’ strong yields eventually make up for any price dip. “If rates go up, or if there is a real anticipation of rates going up, the price of publicly traded REITs will fall,” he says. “Now to what degree, you never know. You will take a short-term hit on the price, but the yield tends to accumulate fairly fast and starts to make up for any losses over the course of one to two years.”

Yet the impact of rising rates isn’t necessarily all bad for REITs. An uptick likely signals a strengthening economy. If so, commercial real estate benefits because there will be more demand for properties, which increases occupancy and pushes rents—and REIT prices—higher, says NAREIT’s Case.

“All things being equal, REITs should suffer when rates rise due to higher interest costs and a decline in attractiveness relative to other fixed-income investments,” says CFP David A. Schneider, founder of Schneider Wealth Strategies, a New York City-based financial services firm. “But all other things are rarely equal. If rates rise because the economy is stronger, vacancies are decreasing, rents are up and real estate prices are rising, REITs could do well.”

Good Income, But Not A Bond
By law, REITs distribute 90% of their taxable income to shareholders as dividends, which is especially important to investors in retirement looking for a steady income stream. But that doesn’t mean REITs are a viable substitute for bonds.

A high-quality bond typically shelters investors during times of stock market upheaval—something a “risk asset” like a REIT does not, Schneider warns. “Therefore, an increased allocation to REITs to boost yields should come from the equity side of the portfolio,” he says.

Moreover, REIT performance can be volatile, he adds. According to Morningstar, in a recent three-year period REITs have been 41% more volatile than domestic large-cap stocks and four and a half times more volatile than the U.S. bond market.

“That doesn’t mean that volatility will always be the case,” Schneider says. “But sometimes retirees can think that anything with a yield is a fixed-income substitute, and the fact is it is not. But that doesn’t negate its value as a piece of the overall investment pie.”

Somewhere Between Stocks And Bonds
As an investment vehicle, REITs possess characteristics of both stocks and bonds. Because they have a contractual rental stream and because they offer the capital preservation tied to a tangible asset, they mimic bonds, Crowe says. Yet commercial real estate ebbs and flows with the economy. When a lease ends, rents adjust with market realities, meaning those rates can go up or down, giving REITs an equity-like component.

Yet commercial real estate sways to its own rhythm separate from the stock market. According to NAREIT’s Case, the commercial real estate cycle typically lasts about 18 years, while the stock market’s cycle averages four. He estimates the sector is about eight years into its current cycle. “If this market cycle is like previous ones, we still have close to 10 years of bull market ahead of us,” he says.

 

The Diversification Factor
Ideally, an investment portfolio straddles four fundamental asset categories: cash, stocks, bonds and real estate, Case says. Publicly listed REITs offer a viable avenue for nearly every investor to hold commercial real estate.

Beyond the ability to trade into commercial real estate through the public markets, REITs diversify a retirement portfolio, which, in turn, can reduce its volatility, Case says. “That’s particularly important to people who are in or near retirement,” he says. “It’s very stressful to see the balance of your total portfolio go down.”

Schneider echoes those thoughts, noting that REITs run counter to the stock market. “REITs are total return investment vehicles that offer diversification benefits that may improve the risk and return profile of a traditional stock and bond portfolio,” Schneider says. “REITs are a good way of getting an equity-like return while diversifying away from traditional equities and bonds. That is what makes them attractive for people in retirement or any other stage of life.”

Simon Moore, the chief investment officer at FutureAdvisor, which manages clients’ retirement portfolios digitally, says REITs act as a “reasonable hedge” against inflation given the ventures are tied to real property. “We don’t necessarily see inflation spiking anytime soon,” he says, “but given we are managing retirement portfolios on a multi-decade view, it’s risky to discount the scenario.”

When piecing together an investment portfolio, Schneider places about 10% of a client’s total equity exposure in REITs. In a typical 60/40 stock-bond mix, he carves out 10% of the 60% stock portion for investments in globally diversified REITs through either REIT funds or ETFs. “Global REITs are an even better diversification tool,” he says, “since not only are you investing in real estate, which is a different asset class than stocks and bonds, but you also introduce real estate from different economies around the world.”

When picking a REIT fund or ETF, Schneider leans toward low-cost, well-diversified, passively managed index funds. He prefers vehicles containing all major property sectors.

Schneider further points out that since REIT income is taxed at ordinary income rates, not dividend rates, they are best owned inside of a qualified retirement plan or other retirement account. He prefers equity REITs over mortgage REITs. Though mortgage REITs can be enticing to a retiree or near-retiree because of their high yields, Schneider cautions they are more of an interest rate play than a true real estate investment. “How those will perform in a rising interest rate environment or in an environment where the yield curve flattens is questionable,” he says.