Rising interest rates to test REIT strength even as investors seek diversification

Attractive yields aside, real estate investments wrapped in a mutual fund are not bonds.

A strong rally in real estate funds could be headed for a pause as the market — and investors — start to anticipate a rising interest rate cycle.
The broad category of real estate mutual funds, as tracked by Morningstar Inc., gained 28% last year, more than doubling the 13.7% gain in the S&P 500 Index, but is up a slight 1.6% this year amid the looming threat of higher interest rates. The category nonetheless is far outpacing the paltry 19 basis points the S&P has gained through Monday.
Historically, real estate investment trusts react negatively to rate hikes but tend to adjust and perform well during longer-term rising-rate cycles, according to Rick Romano, managing director and portfolio manager at Prudential Real Estate Investors.
“When rates are increasing it means the economy is improving and that means rents are increasing, occupancy rates are increasing, and growth rates for REITs are increasing,” he said.

Source: 2015 Morningstar, Inc.

Note: net assets through 02/28/2015, YTD Return through 03/13/2015

Of course, within the real estate space, the categories with the shortest leases have the biggest pricing power advantage.
Hotels, which can adjust prices throughout the day, are best positioned to adjust to rising rates, while some nursing home facilities might have leases that are secured for 20 years or more, Mr. Romano explained.
In between the extremes of daily pricing at hotels and multi-decade leases at senior-living facilities are mid-range leases in the form of self-storage businesses that have monthly durations and apartment buildings with annual durations.
“The longer the lease duration, the more bond-like the REIT will be,” he said.
That is an important consideration for financial advisers who are allocating client assets to real estate investments for diversification and income, the two main characteristics of real estate investments.
Todd Rosenbluth, director of mutual fund and ETF research at S&P Capital IQ, recognizes that “bond proxies like REITs could suffer when the Fed raises rates,” but doesn’t think that’s a reason to abandon the category.
“I don’t think it’s too late to get into real estate because the fundamentals for the U.S. economy are favorable for a number of REIT industries,” he said. “Unlike utilities and other income securities, REITs benefit from an improving economy.”
For example, he added, “If we see more consumer spending, that’s good for shopping centers and apartments.”
“We think it’s good for people to have exposure to the space, because it’s a good diversifier, and it’s a way to play a rising-rate environment and still get income,” Mr. Rosenbluth said.
Despite the ebbs and flows of real estate market over the past several years, a lot of financial advisers are sticking to the asset class for its presumed diversification characteristics.
“With my clients, I keep real estate typically at about 5%, as a diversifier that doesn’t correlate to other things in the portfolio and comes with a higher yield,” said Chris Chen, owner of Insight Financial Strategists. “As a believer in fully diversified portfolios, I want to keep REITs in there,” he added.
Mr. Romano of Prudential describes REITs as hybrid between stocks and bonds, and he believes that REITs are well-positioned to increase dividend yields by as much as 10% this year, up from a current average base of around 4%.
But he also downplays the strong performance of 2014 as the category catching up from weak performance in 2013, relative to the S&P.
In 2013, the REIT category gained 1.6%, while the S&P gained 32.4%.
“Compared to everything else, REITs looked inexpensive,” Mr. Romano said. “There was very little supply being added, and demand continues to improve, thanks in part to the strong jobs growth we’ve been experiencing.”
Keith Singer, owner of Singer Wealth Management, advises his clients to hold about 10% in real estate investments. And he is currently most bullish on the category based on the unusually wide spread between some of the higher yielding REITs and the 2.08% yield on the 10-year Treasury.
“Historically, the spread between REITs and the 10-year Treasury was 300 basis points, but right now you can get 7% yields all day long, and that’s a spread of about 5%,” he said. “I like real estate because it’s not as correlated to stocks and it’s an inflation hedge.”
The correlation to stocks is one area that could depend largely on how an investor is accessing real estate.
While it is true that less-liquid, and typically more expensive, non-traded REITs are expected to be less correlated to equities, that benefit might fade away with real estate wrapped inside mutual funds.
“Real estate-oriented mutual funds are used more by retail investors, and if we should see weakness in the broad equity markets, I believe there’s a high risk of higher correlation with equity markets because it has been turned into a liquid asset,” said Steve Wruble, chief investment officer and head of investment research at FolioMetrix.
Mr. Wruble also believes last year’s performance for the category was a reversion to the mean and that some investors might be misusing REITs as fixed income proxies.
“We think of REITs as enhanced equity exposure, and they are not a substitute for bonds, even though they are being used that way,” he said. “With mutual funds investing in REITs, we flat-out say they will most likely act like a stock, especially in a downturn.”