Income-minded investors with a heavy tilt toward real estate investment trusts and related exchange traded funds do not need to worry too much about rising interest rates negatively affecting their REITs positions.
“REITs are more than just a fixed series of cash flows. They have some economic sensitivity that can cause them to rise when economic conditions improve, which is when rates usually rise,” according to an IndexIQ research note.
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.
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.
Nevertheless, REITs own interest in properties that can appreciate in value, and as the economy improves, rents on those properties typically rise, bolstering the return on the REITs. The high-flying mortgage REITs segment could also strengthen as default rates and prepayment rates dip as the economy improves.
Looking at past periods of rising rates, during four of the six periods when yields on the 10-year Treasury bond rose by more than 100 basis points, the return on REITs was positive, with a sizeable outperformance in small-cap REITs – small-cap REITs saw a cumulative return of 90%, compared to large-cap REITs’ 6% return.
“Clearly, the returns of the REIT indices do not move lockstep in the opposite direction of interest rates,” according to IndexIQ.
ETF investors interested in gaining exposure to the potential growth of small-cap REITs can look to the targeted IndexIQ US Real Estate Small Cap ETF (NYSEArca: ROOF). The ETF has a 69.0% position in small-caps and 27.4% in micro-caps. ROOF also generated an attractive 5.92% 12-month yield.
For more information on real estate investment trusts, visit our REITs category.