Finke: Is the Time Right for REITs?

Headwinds in recent REIT returns have been attributed to an expected rise in interest rates. REITs have been around for decades, however, and rising interest rates haven't been nearly as harmful to REIT returns as a negative business climate. For example, REIT returns have remained positive during the five periods of rising interest rates since 2002. They even outperformed the S&P during three of these rising rate periods. Between 1979 and 2012, REITS outperformed stocks during the 135 months of rising 10-year Treasury yields and the 95 months of rising Federal funds rates, according to a study by investment management firm Cohen and Steers. They also found that REITs performed better during inflationary periods than during periods of lower inflation.

REITs aren't that sensitive to rising rates because managers have the power to raise rents. This power to raise rents is related to the length of lease. If you have a long-term contract with tenants, you can't change the terms if interest rates or inflation rise. Todd Lukasik, a senior analyst in the real estate sector at Morningstar, explains that some companies "engage in very long-term leases that might be 12 to 15 years on average where the tenant might have renewal options that could turn into a 30 year lease. Those, on my list, tend to be the most sensitive to changes in interest rates." Other companies who manage apartments or self-storage facilities may be more insulated from rising rates.

Reviving Fortunes

The popularity of REITs has exploded since the 1990s. As their prices have increased, the spread between equity market and REIT dividend yields narrowed from 6% in the early 2000s to just over 2% today. With popularity comes greater demand and higher prices. And with higher prices come more modest return expectations. REIT income continues to attract investors, but the potential for future dividend growth is limited by the ability of managers to generate profits from the property market.

Lukasik agrees that demand, and in particular the search for income from investments, has affected REIT valuations. Investors' search for yield has "had a big impact on the share prices of the publicly traded REITs." Despite rising prices, Lukasik points out the potential for growth in sectors such as health care that may be currently underappreciated. Health care REITs have "really taken it on the chin since last May." But REITs own only about 15% of the health care real estate market and Lukasik expects "demand in general to grow long term due to the growing and aging U.S. population."

Another recent REIT trend is the popularity of non-traded REITs, which are not regulated by the SEC* and thus are less subject to oversight and regulation. This lack of transparency has led to some predictable abuses, which resulted in a recent investor alert by FINRA. These investments are often sold as a high income earning product available only to the select few lucky enough to have access. In reality, they often have much higher fees and there is limited evidence of actual net performance advantage (and they can be very difficult to get rid of).

Lukasik notes that "the fundraising in that area has been huge. Those types of firms have emerged rather quickly as competitors to the publicly traded REITs, and in some cases have been acquired by publicly traded REITs as the exit strategy for investors." Are they a good idea for investors? According to Lukasik, "if you invest $100 in the product and maybe $85 to $90 is actually being used to buy properties, investors need to be concerned about what they're actually buying."

Future prospects for publicly traded REITs will depend on the strength of the economy and the demand for rental property. Lukasik is optimistic. First, there isn't much evidence of an oversupply of real estate if the economy continues to grow at a steady pace. "That's been a great environment for landlords," which has "led to an environment where you get rising occupancies, rising rental rates and overall organic growth in REIT portfolios," notes Lukasik. "We expect that slow and steady growth to continue, and that's a great environment in REITs."

Is there a place for REIT investment in a 21st-century portfolio? REITs have provided strong returns historically and are a good complement to stocks and bonds. They enhance diversification and are particularly attractive in tax-sheltered accounts. Worries about interest rates and overvaluation are real, but no more so for REITs than for the current stock and bond markets. As alternative asset classes go, publicly traded REITs provide attractive liquidity, transparency, relatively low management expenses and a winning track record.

* – Editor's note 6/6/14: The author has clarified that REITS may be less subject to market oversight but still must meet SEC requirements.