With interest rates set to rise, perhaps as soon as this week, income investors are understandably concerned about the potentially erosive effect of higher borrowing costs on rate-sensitive assets and sectors, including real estate investment trusts (REITs) and the corresponding exchange traded funds.
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.
For example, the Vanguard REIT ETF (NYSEArca: VNQ), the largest REIT ETF, and rival REIT funds have been struggling this month.
REITs typically perform poorly in a rising rate environment since many investors see the asset as a proxy for bonds when fixed-income returns weaken, reports Rodrigo Campos for Reuters.
Consequently, when rates and yields rise, REITs are sold off on expectations of higher costs for financing real estate acquisitions, and their dividends become less attractive against less risky Treasuries.
“Income hunters have reason to worry. REITs are basically a collection of loans and mortgages, and higher rates mean higher expenses on debt payments and more expensive acquisitions. Investors have been especially fixated about slowing growth in the retail sector, notes Evercore’s Steve Sakwa. “Our response continues to be that the perception of slowing fundamentals is worse than reality,” he says,” reports Crystal Kim for Barron’s.
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.
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.
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.