It has been a tough start to 2018 for real estate investment trust (REIT) investors. Since the start of the year, the REIT indexes have dropped by over 10%.
If you are like me, you hold some REIT shares that have fallen even further. The financial media is blaming rising interest rates, which if true does not give confidence in REIT values for a year when the Fed is expected to keep increasing rates.
Fortunately, history shows that the belief that rising interest rates are bad for REITs value is a false assumption. This current correction for the REIT sector may likely end up as a great buying opportunity for future gains.
Both Forbes and the NAREIT website note that historically REITs have generated returns greater than the S&P 500 during periods of rising rates. Here’s how this can this happen. As income investments, investors tend to lump REITs in with fixed income investments, i.e. bonds. When interest rates go up, mathematically bond prices must fall producing negative returns for bond investors. REIT shares are ownership stakes in businesses. Rising interest rates are usually the result of economic growth. For the REIT sector, an improving economy typically means rising commercial property values and the potential to increase rental rates. A significant portion of the REIT sector sees significantly greater benefits from economic growth than they experience from higher interest expense. These factors are especially true in the current market. Companies have had several years to prepare for higher rates. This means that well managed REITs have locked in low interest rates with long-term fixed rate debt. These REITs should be able to improve profit margins by boosting lease rates, even as they keep interest expenses low.
And then there are REITs to avoid. Stay away from any companies that have variable rate borrowing costs. These will see profits squeezed by rising rates. Avoid REITs that do not have histories of dividend growth. Part of staying ahead of rising rates is to own those REITs that can grow dividends faster than the increases in interest rates and inflation. With the recent drop in REIT values, you can find shares with very attractive yields. The next step is to ferret out companies that will grow dividends at greater than the rate of inflation. Here are three to get started with.