As was widely expected, the Federal Reserve boosted interest rates last week for the first time this year.
With the jobs market strong and other economic data points signaling a robust U.S. economy, the Fed is targeting three rate hikes for 2017, which some investors view as a negative for rate-sensitive asset classes.
Buoyed by the Federal Reserve’s lower for longer stance on interest rates and investors’ seemingly unquenchable desire for income, real estate investment trusts (REITs) and the corresponding exchange traded funds were previously among this year’s most popular income-generating asset classes.
REITs are securities that trade like a stock and invest in real estate directly through property ownership or mortgages. Consequently, revenue are mainly generated through rents or interest on mortgage loans. To qualify for special tax considerations, the asset also distributes the majority of income, about 90% of taxable profits, to investors as dividends.
Additionally, funds such as the Vanguard REIT ETF (NYSEArca: VNQ), the largest exchange traded fund holding real estate investment trusts (REITs), and rival real estate ETFs, surged in anticipation of real estate becoming the 11th S&P 500 sector.
In addition to VNQ, the SPDR Dow Jones REIT ETF (NYSEArca: RWR) and iShares Dow Jones US Real Estate Index Fund (NYSEArca: IYR) are among the most popular REIT ETF plays.
“The REIT stock valuation bubble risk may now be moot (the pendulum has swung meaningfully, removing valuation concerns), but are we now more aware of the bubble risk at the asset level? The answer is yes, we think, but only at the margin. The spread between real estate cap rates and the implied cost of capital remains comfortably wide enough to fend off a bubble, in our view,” according to a Mizuho note posted by Teresa Rivas of Barron’s.
After this year’s run, REITs may be starting to look pricey. Additionally, some market observers believe enthusiasm for real estate becoming the eleventh GICS sector, which was made official in September, was baked into the sector before the event happened. There are other issues to consider as well.
“But a Trump presidency clearly adds an incremental element of economic and cost of capital uncertainty (particularly debt costs). We discuss these issues in more detail later in this report with perspective on how to navigate the changing environment through the lens of US property sectors and individual stock recommendations,” according to the Mizuho note seen in Barron’s.
For more information on real estate investment trusts, visit our REITs category.