With interest rates slowly rising, it may not be surprising that shares of real estate investment trusts (REITs) have been ho-hum lately. Last year, the Standard & Poor’s U.S. REIT index advanced by a lackluster 4.2%, lagging the broad equity benchmark by 5.3 percentage points. And in 2017, through mid-June, the REIT index edged up barely 1.4% while the S&P 500 climbed nearly 9%.

Yet don’t give up on REITs yet. While higher interest rates, which make borrowing more expensive, can take a toll on the sector, advisors are divided on the future prospects for REIT investments. “Uncertainty about interest rates, and especially upward pressure, is typically unfavorable for REITs, since higher interest rates indicate higher operating costs,” explains Kimberly Foss, founder and president of Empyrion Wealth Management, a financial planner in Roseville, Calif. But Foss also points out that that’s not always the case.

“When interest rates rise modestly as the result of a strengthening economy, the increased revenues that REITs can generate can often more than offset the higher costs of borrowing,” she says. “In this type of rising-rate scenario, REITs can still display strong returns. Much depends, of course, on the central bank’s ability to accurately divine the temperature of the economy and respond appropriately.”

Downward Pressure or A Tailwind?
Indeed, Foss is not alone in suggesting that a growing economy can be a definite positive for many REITs. “While rising rates could put some downward pressure on REIT prices initially, the strengthening economy with a solid job market will provide a substantial tailwind for REITs over the medium term,” says Jay Jacobs, director of research at Global X Funds, an ETF provider based in New York.

The strength and direction of such a tailwind may depend on the type of REIT you’re talking about. “In particular, industrial REITs are well positioned given that their warehouse properties stand to benefit from the continued rise of e-commerce,” says Jacobs, “as well as data center REITs, as big data continues to expand.” In other words, brick-and-mortar retail space may be suffering from the rise of internet shopping, but the warehouses and shipping centers and other niche players that facilitate e-commerce are likely to continue reaping benefits.

That’s a theme echoed by many observers. Foss sees “indications that the real estate cycle is entering a mature phase that we would associate with more modest growth expectations. However,” she adds, “commercial, industrial and certain specialized subsectors—data centers, for example—may have more room for upward movement in net operating income over the next several months, which would be favorable for both value and dividend performance.”

REIT Subsectors
Other types of REITs may be less likely to fare as well. “REITs hurt most by rising rates tend to be long-term contract holders, such as [some] health-care REITs and REITs with yield but little to no growth in funds from operations,” says Jeremy Bryan, a portfolio manager at Gradient Investments, a Minneapolis-based RIA with $1.4 billion in assets under management.

Like any other securities, REITs can be buffeted by diverse market forces. In judging one category of REIT over another, many experts stress the importance of adhering to basic, fundamental due diligence. “It is important for investors to understand that REITs operate and behave more like stocks than fixed-income investments,” says Bryan. “While interest rates can affect valuations, REIT investments should be evaluated based on the fundamentals of the businesses, to assure that the dividends paid are not only sustainable, but can grow over time.”

As an asset class, REITs have a role in a truly diversified portfolio. But they come with a degree of inherent risk. “While we believe an allocation to REITs provides value in a diversified portfolio, we also believe it is important for investors to understand the risks and objectives of the asset class,” says Bryan.

The Quality of the REIT’s Assets
To understand those risks, it’s a good idea to understand the particulars of the subsector. Peter Kwiatkowski, director of growth and income strategies at Cincinnati-based ClearArc Capital, says he is currently “neutral on REITs,” but certain subsectors do offer promising potential. “Data centers, industrial and cell-tower REITs are all worth consideration in the current environment,” he says. “We are cautious on office and retail REITs in particular, and generally neutral on the rest.”

In particular, he currently prefers REITs that “tend to have longer duration contracts and cash flows, and thus would be hurt by a move up in rates, but less so if the curve flattens. If rates move up, multifamily REITs and lodging REITs would generally do better because they can reprice their rents more quickly. Just as important is the quality and pricing power contained in the assets the REIT owns.”

On the other hand, Ari Rastegar, founder and CIO of Dallas-based Rastegar Equity Partners, is currently focused on “recession-resilient investments in self-storage and multifamily [real estate] in secondary and tertiary markets,” he says. “It is in these subsectors and markets that we believe we can uncover value-added projects where we can increase cash flow and overall value, delivering preferred returns and capital appreciation for our investors, with a keen eye on managing risks.”

Geographical Distinctions
Drilling down deeper, some experts prefer specific geographies. When it comes to apartment REITs, for instance, Nick Fitzpatrick, a Dallas-based real estate analyst at Axiometrics, a unit of data analytics producer RealPage, says by e-mail, “Markets with a REIT presence that continue to perform well include Seattle … which despite a large amount of new supply continues to see strong growth in rental rates.” He notes 5.4% annual effective rent growth there. Other notable markets, he says, are Orlando, Fla. (with rent growth of 4.8%); San Diego (4.5%); Riverside, Calif. (6.0%); and Phoenix (4.3%).

Looking ahead, he expects the San Francisco Bay Area will bounce back. “Not necessarily back to the double-digit growth rates we saw a year or two ago, but back towards the top performing markets in the country by the end of 2018,” says Fitzpatrick. Other cities likely to gain momentum are Dallas and Houston, he says, largely because of their job growth.

REIT Mutual Funds and ETFs
Besides the range of individual REITs, many investors prefer REIT mutual funds and ETFs. “A broadly diversified, low-cost REIT fund or ETF is the best way to get exposure to REITs as an asset class, for long-term investors,” says Brent Lindell, a market manager at Savant Capital Management, an independent, fee-only advisor based in Madison, Wis.

Naturally, there are pros and cons of each, and some advisors disagree altogether, given present circumstances. “Selectivity will be more important going forward in the REIT sector,” says ClearArc’s Kwiatkowski. “Therefore, we would be cautious about owning REITs in a passive manner.”

Still, Jacobs at Global X Funds cautions that “individual REITs can take on significant idiosyncratic risks related to individual properties or geographies.”
He argues that such risks can be mitigated through a fund structure—though he prefers ETFs over mutual funds, for their “liquidity, transparency and tax efficiency,” he says.

The menu of REIT offerings doesn’t end there. Rastegar prefers private equity real estate over mutual funds or ETFs. His reason: “their agreed-upon longer time horizon, essentially swapping liquidity for historically superior returns and lower quarterly volatility, let alone day-to-day volatility. They also may present tax advantages and other benefits,” he says.

Non-correlated Diversification
The breadth of REIT offerings is part of their appeal and what makes them tricky. “REITs were designed as a structure to allow retail investors at every level access to various styles of real estate,” notes Rastegar. “That part has been a success. There are well over 200 publicly traded REITs and numerous nontraded REITs. Each has its benefits and challenges.”

Given these choices, savvy advisors must stay informed and be prudent. “This is hard for the average investor or financial advisor to dissect,” adds Rastegar.

That may be so, but one fact remains clear: The variety of REITs worldwide does lend the asset class certain advantages. “An allocation to REITs diversified globally across sectors should allow long-term investors to benefit from an asset that is only moderately correlated to others in their portfolio,” says Savant’s Lindell.

And he says factors such as rising interest rates should not derail a long-term plan. “It would be imprudent to exclude a diversified allocation to REITs solely based on potential short-term headwinds,” he says. “Our take is to keep REITs as part of the diversified portfolio for the long term. We wouldn’t let our view for what might or might not happen with REITs as an asset class in the next year to year and a half determine whether or not we allocate to REITs as a part of a broader portfolio for a long-term investor.”

Needless to say, only time will tell, as it does for any investment. “Just as with traditional stocks and bonds, we should expect that REITs will defy many of the predictions,” Lindell says.