Is the REIT sell-off over?

If you’re a homeowner, you know that even though they aren’t making any more real estate, property values sometimes act as if they are churning out new continents from time to time. This is one of them. Does this mean real estate is undervalued?

The average fund that invests in real estate investment trusts, or REITs, has been hit by a wrecking ball, losing 9.71% this year, including reinvested interest, according to Morningstar Inc. While other income-generating investments, such as bonds and utility stocks, have tumbled this year as well, REITs have taken the hardest hit.

One reason investors have shunned REITs: They were relatively unaffected by tax reform, since they are already pass-through entities. But the biggest reason is, of course, rising interest rates. The bellwether 10-year Treasury note yield has jumped to 2.89% Friday from 2.49% at the end of 2017. People buy REITs primarily for their yield. At the beginning of the year, REITs yielded an average 4.27%, and those yields, thanks mainly to falling prices, have risen to 4.71%.

Joshua Brown, CEO of Ritholtz Wealth Management, argues that if the yield on the 10-year T-note has hit its top, perhaps REITs and other interest-sensitive sectors have bottomed.

Is that enough to pull investors back to REITs? Possibly.

“The direction of rates is not a good indicator of where REIT shares will move,” said Dave Copp, manager of the TIAA-CREF Real Estate Securities Fund (TIRHX), which has beaten 96% of its peers over the past five years, according to Morningstar. “But at big inflection points, the knee-jerk reaction among investors is, ‘We’ve got to sell.’”

But when rates are rising because of a strong economy, REITs generally fare well. “As long as we are continuing to see job growth, rent increases and occupancy increases, earnings should outpace any interest expense,” Mr. Copp said.

One reason: Many REITs do a good job of hedging their portfolios against rising rates.

“Not may are having their debt payments reprice upwards,” Mr. Copp said. Most have fixed-rate notes for five, 10, even 15 years. Their earnings are never as vulnerable to rising rates as people think they are.

The most recent sell-off has left REITs fairly valued based on the net asset value of their portfolios of commercial real estate, he said. “They’re not pricey. On a valuation perspective, REITs are selling at about a 12% to 15% discount to the net asset value of their properties.” While Mr. Copp looks at funds from operations, a standard REIT valuation metric, he prefers to look at them in terms of what a buyer would pay for those portfolios in a private sale.

Nevertheless, it is late in the economic cycle. Apartment and office space REITs have seen good appreciation, and retail REITs still face the threat of e-commerce.

“Industrial REITs have the longest runway at this point,” Mr. Copp said. One favorite: Rexford Industrial Realty (REXR), which operates mainly in the Los Angeles Basin industrial market.

If your clients are complaining about REIT returns, it’s hard to blame them. But they should also understand that one big reason to own REITs is not income but the fact that as an asset class, they have a relatively low correlation with the broad stock market. And sometimes, that means that they go down when the Standard & Poor’s 500 goes up.