Have REITs peaked?

Real estate investment trusts (REITs) have turned in a solid performance recently.

The FTSE NAREIT All REITS Index has moved higher for each of the last six years, including a 27.2 percent total return increase in 2014. Plus, several REITs generated total returns over 60 percent for the year.

Several factors drove these results, including an improving economy and unexpectedly lower interest rates. Could the party be coming to an end?

The index increased 5.6 percent in January 2015 but fell by 2.6 percent in February.

While February's drop certainly isn't one of the index's more volatile downside moves — it fell by over 8 percent between May and August 2013 on interest rate hike scares — it could reflect the consensus that rates will move higher in 2015.

This prompts the question: Will higher rates offset the benefits of continuing economic growth that's helping many property types?

Business outlook

If this concern over higher rates' impact on REITs' returns sounds familiar, you're right. It's popped up each time observers believe the Fed will finally start bumping up rates.

In July 2014, Matthew Werner, CFA and his fellow analysts at Chilton Capital Management in Houston, considered the risks facing REIT investors in their report, "This Bull has Room to Run: Why 2014 is Not Comparable to 2007."

The report focused on interest rates and the underlying fundamentals: debt and dividend payout ratios, new property development and the spread between 10-year Treasury yields and REITs' implied capitalization rates.

"Headwinds like higher interest rates could temporarily derail REIT total returns, but our positive forecast for the underlying properties has very little near- to medium-term risk in it," the authors explained. In fact, higher interest rates will only help to further constrain new development, which would continue to tilt the supply and demand dynamics in favor of current landlords."

Occupancy rates support the notion that most REIT sectors aren't oversupplied.

According to a Citigroup report cited by the Wall Street Journal in late-December, fourth quarter 2015 occupancy rates across all the REIT sectors was a record-high 94.5 percent. Occupancy varies across the sectors, of course, but overall the country's economic growth is benefiting property owners.

History lessons

In the short term, of course, rate increases tend to hit REITs' returns hard, and it's not uncommon for the index to drop 5 percent or more in a month.

Still, even with the market accepting a likely interest-rate high in June, the FTSE NAREIT All REIT Index is up 1.4 percent in March (through March 19). That puts it ahead of all other major indexes, including the Nasdaq, which is up 0.6 percent in the same three-week period. (This is after the FTSE NAREIT index improved 5.6 percent in January, and then weakened 2.6 percent in February.)

Furthermore, a longer-term perspective suggests such swings are aberrations. Steve Wruble, CFA, chief investment officer and head of investment management research with FolioMetrix in Omaha, Nebraska, shared some statistics his firm has calculated.

The group looked at monthly returns from early-1992 through June 2014 to calculate correlations between the Dow Jones Equity All REIT Total Return and the Dow Jones Composite All REIT Total Return Indexes with the 10-year Treasury Rate return.

The REIT Indexes show negligible correlations with the 10-year Treasury. Between 1992 and 2014, the monthly All REIT index had a correlation of 0.01, and the Equity Composite was 0.00. Using annual results produced higher correlations: 0.24 for the All REIT and 0.23 for the Equity Composite.

The correlation with the S&P 500 was much higher, however, the report notes: The REIT index "had stronger positive correlation with the S&P 500 and that correlation only got stronger when looking at monthly returns since 2008. The correlation changed from 0.56 when looking at monthly returns since 1992 to 0.8 when looking at monthly returns since 2008, meanwhile the (REIT indexes') correlations with 10-year rate for both time periods remained close to 0."

Higher rates affect REIT types differently, however, Wruble points out. Mortgage REITs are likely to prove more sensitive to rate increases than equity REITs.

Drilling down

Industrywide REIT indexes provide a useful overview but don't fully convey the variation among the different property sectors' returns.

In 2014, for instance, residential property REITs generated a 40.0 percent total return and health-care REITs were the second-strongest sector at 33.3 percent. At the other end of the spectrum, timber (8.6 percent) and freestanding retail properties (9.7 percent) came in below the average.

The point is that while REITS share a degree of common exposure to macroeconomic trends and the stock market's performance, each sector and each REIT, faces idiosyncratic opportunities and risks.

Some sectors may have peaked, but the variety of investment opportunities and the resulting opportunity for diversification can help investors identify sectors and REITs with sustainable performance, experts say.

It's not just a question of price performance, though, Wruble points out: REITs' generous yields are an important element in their returns and maintaining investor support.

"I believe a lot of advisors look at REITs, not as much from market-upside participation, which they' received over the last several years, but also from an income perspective," he said "We're still at levels where bond yields are incredibly low, and that's difficult to support retirement."

Meanwhile, REITs could turn in another year of solid performance, according to Jay Leupp, managing director and senior portfolio manager at Lazard Asset Management, who thinks "there's still room to run" in 2015.

"We don't think rates are going to rise as much as most pundits," he said, at a NAREIT meeting in late-February. "We do still see very strong real estate fundamentals… and we still see rent growth and earnings growth tracking ahead of inflation. In our view, this adds up to a pretty good year for REITs."

Total REIT returns could be 10-15 percent, according to Leupp.

Have REITs peaked?

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Have REITs peaked?

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