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 spent significant time in 2016’s early stages as a preferred income-generating destination.
However, that theme evaporated amid concerns that real estates were stocks overvalued and as the Federal Reserve approached its first interest rate hike of the year, which was delivered last month. With the Fed targeting three rate hikes this year, popular REIT ETFs such as the iShares Dow Jones US Real Estate Index Fund (NYSEArca: IYR) and the Vanguard REIT ETF (NYSEArca: VNQ), the largest REIT ETF, were pinched.
Enthusiasm for REITs also waned after real estate became the 11th S&P 500 sector last year, separating from financial services. Now, some market observers believe the sector is under-owned and could offer rebound potential this year for income investors.
“Real estate, which was broken out of the financials at the end of the summer to create an 11th distinct sector, is the most underweighted sector by active managers, according to research from Bank of America Merrill Lynch,” reports CNBC.
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, REITs provide diversification benefits as the asset shows a lower correlation to stocks and bonds. However, the asset category has recently experienced heightened volatility due to interest rate risks. Some investors fear REITs will act negatively in rising interest rate environment. The high dividends in REITs are attractive in a low-rate environment but are less enticing once safer Treasuries show higher rates.
“In fact, the BofAML research team has found that overweighted stocks tend to outperform and underweighted to underperform; unsurprisingly, two of the three most under-owned stocks now are Realty Income Corp. and Federal Realty Investment Trust, they found,” according to CNBC.
Higher interest rates are seen as punitive to REITs’ cash flow, which can hinder the company’s ability to boost dividends, the primary allure of the asset for many investors.
For more information on real estate investment trusts, visit our REITs category.
