Sluggish economy helping REIT performance

Demand overshoots supply, supporting higher occupancy and rents

Jul 8, 2014 @ 12:50 pm

By Jeff Benjamin

real estate, real estate investment trust, REIT, mutual fund
+ Zoom

The strong first half of the year for real estate investment trusts has started to raise questions about how well the category can perform if interest rates start to rise. But industry pros are calling such analysis short-sighted and wrong.

“I don't think interest-rate hikes are a big threat to REITs, and I have a very optimistic and bullish outlook for real estate in 2014 and two years beyond 2014,” said Kevin Mahn, president and chief investment officer of Hennion & Walsh Asset Management.

While the real estate industry relies heavily on debt and leverage, any negative effects from a rising-rate cycle is likely to be offset by favorable supply-and-demand fundamentals, according to Marc Halle, managing director for Prudential Real Estate Investors.

“Right now we're seeing generational lows, in terms of the amount of new (commercial construction) product being delivered to the market,” he said. “REITs offer strong income and they are a natural hedge against inflation, and it is driven by supply and demand.”

Through June 30, REIT funds, as tracked by Morningstar Inc., had a category average gain of 16.6%, which compares with 7.1% for the S&P 500 Index. That's a big swing from 2013, when the S&P gained 32% and REIT funds rose just 1.6%.

REIT funds are also currently averaging 3.7% dividend yields, nearly double the S&P's 2%.

What is working and will likely continue to work in support of the REIT space is the sluggish pace of the economic recovery, which has reduced commercial development to a slow crawl over the past six years.

The average property occupancy rate across all REIT portfolios is now measured at 93.6%, which is closing in on the prior occupancy-rate peak of 94.3% in 2007.

This represents both market demand and pricing power for property owners.

“You've already seen hotel rates go up and you're seeing rental rates go up in self-storage and multi-family housing,” Mr. Halle said. “We haven't seen construction of any type since [the start of the financial crisis], and then you add to that the fundamental reality that, with real estate, you can't just create supply overnight.”

Todd Rosenbluth, director of mutual fund and ETF research at S&P Capital IQ, acknowledged the supply-and-demand scenario, but attributed much of the REIT category strength this year to low interest rates.

“As we've seen rates come down a bit this year, investors are looking for alternatives with steady income streams,” he said. “It's true that demand has been strong and supply has not kept up and that's a good thing for REITs.”

Meanwhile, Mr. Rosenbluth said investors should not be overlooking the risks associated with rising interest rates.

“The supply-and-demand fundamentals can stay strong, but if the yield on the 10-year Treasury moves up to 3% (from 2.56% today), the REIT yields will be less compelling because investors will be taking on risk they're not being compensated for,” he added.

But Mr. Halle insists that rising rates need to be considered in the context of what is essentially a fragile economy.

“In a market like today, if rates are going to be rising it's because the economy is doing better and markets are generally in equilibrium,” he said. “In that kind of increased activity, rents tend to rise.”

Burland East, manager of the Altegris/AACA Real Estate Long-Short Fund (RAAAX), said he welcomes rising rates because they would represent inflation and “inflation is real estate's best friend.”

“Inflation will drive interest rates higher, but it also drives prices higher,” he said. “Right now we have almost no inflation but rents are going up between 4% and 6% a year.”

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