REIT investors brace for a December rate hike

Riding out the short term for the longer-term upside

Oct 13, 2016 @ 2:55 pm

By Jeff Benjamin

A solid run for the real estate category this year, boosted by it becoming an eleventh sector of the S&P 500 Index, has lost some steam recently amid fresh concerns of a December interest rate hike.

While most market watchers say such short-term thinking is not a prudent investment strategy, that doesn't always prevent investors from reacting with their fear and greed instincts.

“REITs tend to underperform coming into a Fed hike, and outperform on the other side of a rate hike,” said Scott Crowe, chief investment strategist at CenterSquare, the real asset division of BNY Mellon.

Rising interest rates are generally viewed as negative for investments like real estate investment trusts, which are heavily dependent on debt financing.

Mr. Crowe is among those who firmly believe the Fed will raise rates in December, as it did last year. But he also thinks it's a mistake to fear a negative correlation to reits.

“Higher rates are bad for REITs, but what that assumption misses is that the rate that matters for REITs is long-term bond yields, because that represents the cost of debt for real estate deals,” he said. “The Fed doesn't set long-term rates.”

Christian Magoon, chief executive of Amplify ETFs, said REITs could face some short-term risk of cash flow issues in the event of a rate hike, but the long-term implications of a rate hike will benefit the category.

“If rates go up and REITs don't raise their cash flow to keep pace then the value of their shares should decline, but this is a bigger risk in the short term versus the long term as it's easier and quicker to raise interest rates than rental rates,” he said. “Over the long term, however, a rising interest rate environment should be indicative of a growing economy which will allow REIT cash flows to climb.”

According to Mr. Crowe of CenterSquare, the performance of REITs gets better furthest from a rate hike. With the Fed's short-term rate having been held artificially low for nearly eight years, historical patterns might not perfectly line up, but during past rate-hike cycles REITs averaged a 1.93% decline 12 months prior to the hike, and a 45 basis point gain three months prior.

Three months after a hike, REITs gained 1.44%, then 3.4% six months after the hike, and were up 7.71% 12 months after the hike.

According to Mr. Crowe, the REIT sector is down about 10% from its August peak, and is currently trading at about a 10% discount to commercial real estate values.

With that in mind, Todd Rosenbluth, director and mutual fund and ETF research at CFRA, said investors and financial advisers have options for betting for or against real estate in various income ETFs.

For those not buying the rate hike argument, or unfazed by the short-term impact, there are a few income-oriented ETFs with ample real estate exposure.

The $335 million Global X SuperDividend US ETF (DIV) has a 20% weighting in real estate, the $2.1 billion WisdomTree MidCap Dividend ETF (DON) has 16% in real estate, and the $14 billion SPDR S&P Dividend ETF (SDY) has 9% allocated to real estate.

On the other end of the spectrum the $16 billion iShares Select Dividend ETF (DVY) and the $22 billion Vanguard Dividend Appreciation ETF (VIG) each have zero exposure to real estate.

“This is potentially a buying opportunity if you believe REITs can do well in rising rate environment,” Mr. Rosenbluth said. “And it's also a buying opportunity if interest rates don't go higher.”

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