Real estate investment trusts, once the darlings of income-starved investors, have lost enough momentum over the past few weeks to justify a fresh look at any commitment to the asset class.
Even staunch REIT bulls usually acknowledge that equity REITs, as a broad category, are at least fully valued. The less bullish, meanwhile, are saying that the strategic REIT play relative to stocks is over and the only play at this point is tactical.
“We feel as though all the benefits REITs are getting are from the low-interest-rate environment, and we think the upside has become increasingly limited,” said Jack Chee, a senior research analyst at Litman Gregory Analytics LLC. “At this point, we think we're in the late innings of all the positives for REITs.”
Litman Gregory has been cautious about REITs for the past few years, but recent chatter about the Federal Reserve's quantitative-easing policy has triggered enough volatility to remind investors just how sensitive REITs are to interest rates.
For a sense of that volatility, consider that through May 21, the Vanguard REIT Index ETF (VNQ) was up 19.6%, compared with 17% for the S&P 500.
But since then, when market forces started reacting to concerns that the Fed could re-evaluate its commitment to keeping rates at record lows, REITs fell by 10%, while the S&P 500 fell just 2%.
As a result of the sudden dip, the Vanguard REIT Index's year-to-date gain has been trimmed to 7.6%, lagging the S&P 500's advance of 11.6%.
“Rising rates definitely present a head wind where REITs will tend to lose a little relative appeal,” said Brad Mook, a senior investment analyst at SEI Investments Co.
THREE STEPS AHEAD
Even though Federal Reserve members have only hinted that if the economy continues to improve, it will move toward tapering its pace of Treasury buying, the market is already three steps ahead.
The closely watched 10-year Treasury bond yield, for example, has been hovering above 2.2% since May 22, representing a 25% increase from the beginning of the year.
One of the reasons that higher rates pose a challenge to REITs is that they open the door for higher-yielding alternatives such as bonds.
The total market capitalization of equity REITs is only about $600 billion, which makes them particularly vulnerable to market mood swings, according to Mr. Chee.
For perspective, the market cap of Apple Inc. (AAPL) is about $400 billion.
“We've seen some crowding into the space because we've seen a lot of generalist investors move into REITs over the past few years in order to capture some of the yield,” Mr. Mook said. “But over the past couple of months, we've seen some pulling back because those generalist investors tend to have a broader view of the world, as opposed to just being REIT investors.”
Mr. Mook pointed out that even though REIT fundamentals remain solid and will continue to benefit from an improving economy, the asset class will lose those investors seeking growth and higher yields.
“In an environment where there's no growth, returns can come from income, but if growth accelerates, income becomes less important to some investors,” Mr. Mook said. “In a stronger economy, there may be other opportunities for investors.”
Another, less obvious obstacle that REITs face is the recent re-emergence of the commercial-mortgage-backed-securities market.
According to Mr. Chee, the CMBS “debt capital has been out of the market but is coming back, representing more competition for REITs in making acquisitions.”
CMBS typically represent a financing arm for private real estate investors and therefore tend to use more leverage, thus pushing acquisition prices higher.
“They do pose a challenge for REITs because they might be able to pay more for a property, but it also means that real estate values will continue to appreciate,” said Jon Cheigh, executive vice president and portfolio manager at Cohen & Steers Inc.
In a sense, the CMBS factor could be a double-edged sword for REITs in that it could limit growth through acquisitions but indirectly drive up the values of properties that the REITs already own.
