With the Federal Reserve raising the benchmark rate on Mar 15 by a quarter of a point for the second time in three months, the market is anticipating a capital flight from interest rate sensitive sectors like real estate investment trust (REIT). But things don’t appear too bad for REITs.
The magnitude of the hike is in line with expectations and the Fed’s approach seems to be a balanced one. With the rate hike news, U.S. government debt prices climbed while bond yields, which have an inversely proportional relation with prices, moved lower.
Amid this, REITs are back in the spotlight. They are often treated as bonds for their high dividends and therefore treasury yields end up playing a significant role in their price movement. When treasury yields decline, REIT stocks look attractive.
In fact, on Mar 15, the FTSE/NAREIT All REITs Index managed to record a total return of 1.98%, compared with the 0.84% increase of the S&P 500 Index. On the other hand, the yieldon the 10-year Treasury note declined to 2.51% on Mar 15 from 2.60% the previous day. However, for the year 2017 through Feb 28, 2017, the FTSE/NAREIT All REITs Index managed to record a total return of 4.42%, compared with the 5.94% rise registered by the S&P 500.
What’s in the Cards?
Moving ahead, rate hike and treasury yields should surely be much talked about as REITs significantly depend on debt for business. However, assuming that the entire industry will crumble under a rising rate environment is wrong. This is because, REITs cater to a wide range of real estates and each asset category has its own demand-supply dynamics that end up playing a vital role in determining its performance.
Also, the pace and magnitude of rate hikes, and the capacity of REITs to absorb these increases are expected to substantially shape the REIT industry. Thus, factors like lease durations and pricing power in the market would command much attention.
Of course, fiscal stimulus like tax reduction and infrastructure spending expected under the Donald Trump presidency are likely to boost demand, fuel economic growth and push up inflation. And when economic growth gathers steam and inflation rises, prices of real estate generally increase while rent and occupancy of properties go up. However, not every category of real estate is likely to get an equal boost and not all locations are poised to flourish.
This was quite evident in the fourth quarter when office and industrial asset categories continued to experience high demand though supply issues in a number of markets like New York and San Francisco raised concerns for some of the residential REIT stocks. Also, dwindling mall traffic and store closures amid aggressive growth in online sales kept retail REITs on tenterhooks.
So investors need to remain cautiously optimistic and look beyond the rate factor. It is important to first study the fundamentals of the underlying asset category before making any investment.
Dividends Standing Tall
Dividends are by far the biggest attraction to invest in REIT stocks, and income-seeking investors continue to find reasons to prefer them. This is because, as of Dec 30, 2016, the dividend yield of the FTSE NAREIT All REIT Index was 4.32%, which handily outpaced the 2.1% dividend yield offered by the S&P 500.
Moreover, as of Feb 28, 2017, the dividend yield of the FTSE NAREIT All REIT Index was 4.08%, well ahead of the 2.0% dividend yield of the S&P 500. Over long periods as well, REITs have outperformed the broader indices with respect to dividend yield.
U.S. law requires REITs to distribute 90% of their annual taxable income in the form of dividend to shareholders. This unique feature made the industry stand out and gain a solid footing over the past 15–20 years.
Further, in recent years, REITs managed their balance sheets well and focused on lowering debt and extending maturities. As a result, the debt-to-total market capitalization of the Equity REIT market reached 31.9% on Sep 30, 2016, marking the lowest level in 20 years.
Also, REITs have indeed been proactive in the capital market, with the stock exchange-listed REITs raising a total of $59.3 billion in public capital in 2015 and collecting $69.6 billion in capital offerings in 2016. Moreover, as of Feb 28, 2017, REITs raised around $9.8 billion in capital offerings.
Moreover, reforms to the Foreign Investment in Real Property Tax Act (FIRPTA) are expected to offer easy access to capital from foreign investors for publicly traded REITs and commercial real estate.
Exploring the Sector Through ETFS
We believe that this is the right time to explore the sector through Exchange Traded Funds (ETFs), so as to reap the benefits in a safer way. Considering the return prospects from dividend income and capital appreciation, we have tracked the following REIT ETFs that could be worth considering:
Vanguard REIT ETF (VNQ - Free Report)
The fund, launched in 2004, seeks investment results by tracking the performance of the benchmark – MSCI US REIT Index – which is used to gauge real estate stocks. The fund consists of 158 stocks, which acquire office buildings, hotels and other real estate property. The top three holdings are Simon Property Group Inc. (SPG), Public Storage (PSA) and Prologis, Inc. (PLD). It charges 12 basis points (bps) in fees. VNQ managed to attract around $33.4 billion in assets under management as of Mar 15, 2017.
iShares U.S. Real Estate ETF(IYR - Free Report)
Launched in 2000, IYR follows the Dow Jones U.S. Real Estate Index that measures the performance of the real estate industry of the U.S. equity market. The fund comprises 126 stocks with top holdings including Simon Property Group Inc., American Tower Corporation (AMT) and Public Storage. The fund charges 44 bps in fees (as on Dec 31, 2016) and its 30-day SEC yield is 3.28% (as of Feb 28, 2017). As of Mar 15, 2017, it had around $4.5 billion in assets under management.
SPDR Dow Jones REIT ETF(RWR - Free Report)
Functioning since 2001, RWR seeks investment results of the Dow Jones U.S. Select REIT Index. The fund consists of 102 stocks that have equity ownership and operate commercial real estates, with the top holdings being Simon Property Group Inc., Public Storage and Prologis. The fund charges 25 bps in fees while the 30-day SEC yield is 3.52% (as of Mar 14, 2017). Its assets under management were $3.1 billion as of Mar 15, 2017.
Schwab US REIT ETF(SCHH - Free Report)
This fund debuted in 2011 and tracks the total return of the Dow Jones U.S. Select REIT Index. The fund consists of 123 stocks that own and operate commercial real estates. The top three holdings are Simon Property Group Inc., Public Storage and Prologis. It charges 7 bps in fees while the 30-day SEC yield is 3.47% (as of Mar 15, 2017). Further, SCHH had $2.9 billion in assets under management as of Mar 15, 2017.
First Trust S&P REIT Index Fund(FRI - Free Report)
Launched in May 2007, FRI is an ETF that seeks investment results of the S&P United States REIT Index. The fund comprises 157 stocks with the top holdings being Simon Property Group Inc., Public Storage and Prologis. The fund charges 48 bps in fees and had a 30-day SEC yield (as of Feb 28, 2017) of 3.52%. FRI had about $228.8 million in assets under management as of Mar 15, 2017.
iShares Cohen & Steers REIT ETF(ICF - Free Report)
Incepted in 2001, this fund follows the Cohen & Steers Realty Majors Index. The fund comprises 30 stocks with the top holdings being Public Storage, Simon Property Group Inc. and Equinix, Inc. (EQIX). The fund charges 34 bps in fees (as of Dec 31, 2016), while the 30-day SEC yield is 2.93% (as of Feb 28, 2017). Its assets under management were $3.2 billion as of Mar 15, 2017.
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