Attractive Investments

As such, existing landlords have experienced improved occupancy rates, greater bargaining power relative to tenants, and nice increases in same-store net operating income. Similarly, the low interest rate environment has allowed REITs to refinance debt and preferred equity at very favorable rates, saving hundreds of millions—if not billions—of dollars in aggregate industry financing costs.

Also, we think investors were drawn to the attractive dividend yields of REITs as interest rates fell, driving up asset prices. Our view is that the generally favorable backdrop REITs have faced over the past few years will change, although the timing remains uncertain.

In April, our REIT coverage looked roughly 15% to 20% overvalued. With the recent rise in rates and drop in REIT prices, our REIT coverage looks slightly overvalued today relative to our expectations, and we think investors should be very selective when considering what REITs to own in their portfolios.

Paolone: What's been important for the group, as it relates to the stocks, is that we've been in a fairly modest-growth economic environment. We've also been in an environment in which interest rates have been low and investors have sought out some income as an investment strategy. Those things all play into REITs quite well.

You've seen a good amount of capital flowing into the space, as well as into direct real estate for that matter as this asset class, broadly speaking, delivers good risk-adjusted returns. I think that was the big driver to the performance over the last few years.

Looking ahead, I would say a couple of things. One is that fundamentally the business looks like it continues to improve slowly as job growth continues to move ahead in the country. At the margin, landlords are gaining a bit more pricing power, occupancies are rising, and there's not a whole lot in the way of new supply of commercial real estate generally speaking. As a result, cash flows at the companies are growing.

The second item, though, relates to interest rates and just how this group of stocks may or may not fit in to the broader market. If we are going to have an environment in which rates move rapidly higher, these are going to be stocks that face headwinds, because they were beneficiaries of the search for yield and because they offered some relative safety in a fundamentally mediocre period of time.

But presuming that if rates are going up and you have more robust economic activity as your backdrop, the risk is that you see a flight of capital out of REITs into other areas of the market, perhaps into more cyclical sectors. You saw some of that in the very end of May and into June, when you saw the move in the 10-year Treasury and the market sentiment shifted from being more income-oriented and to being out of sort of bonds and yield instruments. REITs bore the brunt of that.

How can REIT investors adapt to likely higher interest rates?

Guinee: We think the best way to hedge against rising interest rates is to focus on REITs which have higher-quality portfolios, have internally generated earnings growth and are valued by investors more on net asset value than on dividend yield.

Jones: Our historical correlation work and analysis suggests that over the medium and long term, REIT total returns have not been closely correlated to changes in interest rates. However, over the short term, significant changes in the interest rate environment can lead to volatility in REIT returns.

Investing in REITs with above-average cash flow growth prospects should be a way to protect against higher interest rates. REITs with above average growth can increase their dividends to potentially keep pace with higher interest rates. We also believe that real estate and REITs with above-average growth should maintain or improve their asset values compared to the sector overall.

Paolone: A couple of broader thoughts are: Number one, move to property types with shorter lease durations, which are things like apartments and industrial perhaps; and, two, focus on companies that over the last few years, as you came out of a downturn, really built up pipelines of developments by repositioning properties.