Everyone knows the old adage that you should never try to catch a falling knife and I have always applied that same philosophy to investing.  When a stock or ETF appears to be in a persistent downtrend it doesn’t make sense to try and step in when the momentum is running against you.

You don’t want to be left feeling the pain of early losses if the price continues heading south.  Such as been the case in real estate stocks over the last four months as rising interest rates have pulled the rug out from under this sector.

I have been warning investors for some time to stay away from both traditional real estate investment trusts and mortgage REITs as rising rates have been a natural headwind for these stocks.  Consider that fixed-mortgage rates recently hit their highest levels in two years on expectations that the Federal Reserve will taper its asset purchase program.   The profitability of these REITs is directly dependent on low interest rates to finance their acquisition and ongoing operating costs.  Higher financing costs make these investments less attractive, which is why they have fallen out of favor with income seeking investors.

Mortgage REITs in particular are highly sensitive to any swift move in bond yields because they borrow short-term money very cheap and use it to buy long-term debt.  This enables them to pocket the spread on interest rates and distribute the majority of earnings to shareholders.  In addition, they use excessive leverage to juice their returns which in turn makes them more responsive to changes in rates. [Interest-Rate Spike May be Overdone]

We have seen tremendous price compression over the last several months as you can see by the list of these heavily traded ETFs and their percentage off the high (data as of 8/21/13).

  • iShares U.S. Real Estate ETF (IYR) -16.80%
  • Vanguard REIT ETF (VNQ) -16.30%
  • iShares Mortgage Real Estate Capped ETF (REM) -23.66%
  • MarketVectors Mortgage REIT Income ETF (MORT) -22.61%

However, with the 10-Year Treasury Yield rapidly approaching 3% I am starting to look at these REITs in a new light.  I think that the majority of the move in interest rates has been made already and that the expectations for tapering are more than likely baked into the cake.  The future risk is REITs will likely be dependent on whether or not we see additional volatility throughout the broader stock market.

The SPDR S&P 500 ETF (SPY) is currently sitting 3.74% off its highs and still has the potential for more downside.  That being said, stocks have been amazingly resilient this year and betting against them has proven to be an exercise in futility.  Stabilization in interest rates combined with additional strength in stocks could be just what these REITs need to bring them back to life.

The upside of the pullback in REITs is that new capital invested in this sector has the advantage of locking in higher yields along with prices that are near 52-week lows.  For value income investors, taking advantage of these deep discounts is an opportunity that should be considered.  However, I am recommending that if you do decide to wade into the REIT space that you do so with small allocations and a sell discipline to guard against further volatility.

David Fabian is the chief operating officer at Fabian Capital Management LLC.