Real Estate Investment Trusts, along with related exchange traded funds, have rallied this year as interest rates dipped and investors sought out income-generating assets. Now, some are growing concerned that the asset may be overheating.
Year-to-date, the Vanguard REIT ETF (NYSEArca: VNQ) has gained 17.5%, iShares Dow Jones US Real Estate Index Fund (NYSEArca: IYR) rose 15.6% and SPDR Dow Jones Reit ETF (NYSEArca: RWR) increased 17.9%. [A Wonderful REIT ETF]
The benchmark MSCI U.S. REIT Index is up 15% so far this year, whereas the S&P 500 index has only gained 6.5%.
After the impressive run in REITs this year, some are worried that the asset class is vulnerable to rising interest rates and a potential shift to safer fixed-income assets, reports Alexandra Scaggs for the Wall Street Journal.
“You need to be a bit cautious,” Scott Crowe, a manager for the Resource Real Estate Diversified Income Fund, said in the article. “I don’t think the market’s particularly cheap.”
Green Street Advisors calculates that the group is trading around 18 times its adjusted funds from operations, a metric for valuing REITs. In comparison, the asset showed a 15 average reading over the past 20 years.
“REITs are still a little expensive versus stocks,” Jason Moore, an analyst with Green Street, said in the article. However, “versus bonds, they look cheap.”
REITs are companies that operate real-estate properties and generate revenue through rent collection. As a REIT, a company needs to pay at least 90% of its taxable income to shareholders through dividends. Consequently, many investors have turned to REITs as an attractive source of yields.
For instance, VNQ has a 3.0% 12-month yield, IYR has a 3.58% 12-month yield and RWR has a 3.0% 12-month yield. The MSCI U.S. REIT Index was yielding 3.8% as of the end of May. In contrast, the S&P 500 shows a 2.33% dividend yield.
Investors have piled into REITs this year as an attractive income alternative in response to the falling yields in benchmark 10-year Treasury notes. Treasuries yields are hovering around 2.56% after falling from around 3.0% at the start of the year.
Investors should be aware that REITs are sensitive to changes in interest rates.
“The risk of rising interest rates is the biggest risk to the REIT sector,” according to Morningstar analyst Abby Woodham. “Because REITs must pay out most of their income as dividends, they rely on debt for growth. For REITs, higher rates mean more-expensive debt servicing and less business reinvestment. REIT yields also become less attractive relative to Treasuries when rates are high, putting downward pressure on the sector’s valuation.”
For more information on real estate investment trusts, visit our REITs category.
Max Chen contributed to this article.