If you recall, the conventional wisdom among market prognosticators for 2014 was that the Federal Reserve would finally start raising interest rates from historically low levels, which would ding publicly traded real estate investment trusts because investors would ditch these dividend-paying products for the safer yield of bonds.
What happened? The Fed never raised rates, and U.S. REITs skunked the overall equity market that year by doubling both the total return and the dividend yield of the S&P 500.
After the Fed in December raised the federal funds rate by a quarter point—from the 0% rate set in December 2008—and hinted at incremental increases throughout the year (economic conditions willing), where does that leave REITs?
To some real estate watchers, investor concerns about the link between rising rates and REIT performance are misplaced. According to NAREIT, the National Association of Real Estate Investment Trusts, listed equity REIT returns were positive in 12 of the 16 periods since 1995 when interest rates rose significantly.
“When looking at interest rates, you have to ask why are they going up,” says Brad Case, NAREIT’s senior vice president for research and industry information. He explains that interest rates generally go up because the economy is improving and there’s more demand for capital, so the price of capital—i.e., interest rates—increases. Market interest rates are rising because macroeconomic conditions have improved, causing the Fed to raise its policy rates.
“If interest rates go up because of the economy, that’s good news,” Case says. “In other words, it’s the economy, and not the interest rates, that investors should be paying attention to.”
In addition, he notes that REITs have trimmed their use of leverage considerably, so they’re not as sensitive to rate increases. And most of their debt is fixed-rate, which means the value of that debt goes down as interest rates rise.
Cohen & Steers, a New York City-based investment manager specializing in real estate, mirrors NAREIT’s take on REITs and rising rates. In a January report, Cohen & Steers executive vice president Thomas Bohjalian said REITs have historically delivered strong returns when the Federal Reserve raises rates because this usually means the economy is getting stronger. He pointed to the last monetary tightening cycle between June 2004 and June 2006, when the Fed raised the federal funds rate from 1.25% to 5.25%.
During that period, U.S. annual gross domestic product jumped more than 16%; REITs had a cumulative return of 57.9% while stocks rose 15.5% and bonds 5.9%. “While the current environment is not identical, there are key similarities, including strong job growth, an expanding economy and a general expectation of higher interest rates,” Bohjalian wrote.
Real Estate Backdrop
Public REITs come in two flavors: equity REITs and mortgage REITs. The latter provide real estate financing. According to NAREIT, equity REITs represent 90% of the public market. (Non-traded REITs are a separate component of the REIT universe.)
REITs are required to pay out at least 90% of their taxable income to shareholders. In return, they can deduct the dividends paid from their corporate tax bill. The combination of steady dividend income and potential stock price appreciation are big selling points for REITs, which were created by Congress in 1960—incongruently, as part of a tobacco bill—so that the public could invest in income-producing real estate. And they’ve generally delivered solid results for investors during their existence, notwithstanding a few significant troughs along the way.
Case says NAREIT has “44 years of data, and during that period listed equity REITs have provided better returns than the rest of the stock market with a little bit less volatility, which means they’ve provided better risk-adjusted returns as well as a low correlation to the rest of the stock market.”
But listed equity REITs are, after all, equities. And investors in equity REITs suffered grievous losses during the financial crisis, only to see those holdings (if they had held on to them) rocket northward along with the rest of the stock market during the post-crash bull market. That raises questions about the supposed non-correlation between equity REITs and the overall stock market.
Case says you have to look at correlation over a long time horizon. “When you estimate the correlation using monthly returns, it’s about 0.55. But when you look at the correlation over longer investment horizons of six months to a year or five years, the correlation goes down dramatically. It’s about 0.15 when you look at five-year returns, and the reason for that is the return drivers are entirely different.”
Perhaps, but as of February 11th REITs had taken it on the chin along with the rest of the equity market in 2016. The largest REIT-focused exchange-traded funds—the Vanguard REIT Index Fund, SPDR Dow Jones REIT ETF and SPDR Dow Jones REIT ETF—all had lost between 11% and 13%, versus a 10.5% drop in the S&P 500.
Regardless, some investors remain wary of the valuation of public REITs, and see better opportunities on the private side of real estate. Jeffrey Sarti, co-president of Morton Capital in Calabasas, Calif., says his firm has been focused on private markets because it’s a more inefficient space, including private real estate limited partnerships. “That continues to be our focus because we’re still finding opportunities. At a high level, we continue to think [publicly traded] REITs are expensive. Until there’s meaningful dislocation, we won’t spend a lot of time looking at them closely.”
Lazard Asset Management bases the valuations of REITs on a ratio of price to funds from operations (comparable to a price-to-earnings ratio). The firm said in a report that, on that basis, a representative basket of 53 large and investable REITs across all sectors barely traded above its long-term average as of year-end 2015.