Last week, the Federal Reserve boosted U.S. interest rates by 25 basis points, setting the stage for rate hikes as 2017 moves along. That would appear to encourage investors to depart the rate-sensitive real estate sector and its related exchange traded funds.
However, some market observers argue that investors do not need to flee real estate investment trusts (REITs) and the relevant ETFs simply because borrowing costs are rising. 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, may not face as much pressure as previously thought.
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.
“We see U.S. commercial real estate delivering attractive total returns over the next few years in a low-return world. We expect capital appreciation to slow but see operating income growth due to the reflationary backdrop and the potential for property managers to add value by upgrading buildings. Average yields of 3.5% are competitive with 3.4% for U.S. investment grade and an S&P 500 dividend yield of 2%. Demand is strong: Nearly half of institutions in our most recent Global Institutional Rebalancing Survey intended to raise allocations to real estate this year,” according to a BlackRock note posted by Amey Stone of Barron’s.
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.
“We favor industrial and office properties that should benefit from reflation. We are neutral on apartments due to elevated supply and avoid retail properties due to e-commerce competition. We like selected publicly traded U.S. real estate investment trusts and commercial mortgage-backed securities,” said BlackRock in the note seen on Barron’s.
For more information on real estate investment trusts, visit our REITs category.