The Right REITs Can Be Safer than Bonds When Rates Are Rising

Keith Fitz-Gerald Dec 21, 2016

Conventional wisdom has many investors believing that rising rates are bad for real estate investment trusts (REITs for short).

Not so.

In fact, the “right” REITs can be safer than bonds when rates rise.

Here’s two to get you started.

Millions of income-starved investors believe that real estate will get whomped along with bonds and some dividend funds now that Fed Chair Janet Yellen has finally made her move and interest rates are rising.

In fact, that’s not true.

REITs have historically done well when the cost of money is increasing. Between 1994 and 2013, for example, there were nine time periods when interest rates rose by more than 1% (or 100 basis points in trader speak) as measured by the 10-Year U.S. Treasury note.

Six out of nine of those times, REITs provided positive returns despite the fact that those rate chances were roughly four times larger than the measly 0.25% hike Yellen just made and the three additional hikes she says she’s going to make in 2017.

What most people miss is deceptively simple.

Namely that there’s a big difference between a sharp rate spike in the mold of Chairman Paul Volker’s 1970s “torpedo” and the slowest interest rate normalization in history that’s now Yellen’s legacy.

The former is a mechanism designed to shut down inflation and rein in speculation, while the latter is intended to maintain all the things policy makers believe free money makes possible – an improving labor market, consumer spending, and overall demand.

Since 1994, there have been nine instances when rates rose by 1% or more and real estate did just fine.

And if it’s different this time?

I get that question a lot – usually more as it relates to traditional dividends and income than real estate – but either way, it really doesn’t matter much.

The principle is the same – there is a strong correlation between high total returns and the management approach taken to dividend policy over time.

Imagine investing $200 in 1940, $100 of which you put in dividend stocks and reinvested over time and the other $100 of which you put in non-dividend payers. By the end of 2011 the former would be worth approximately $174,000 while the latter would be worth only $12,000, or $162,000 less, according to a study by Dr. Ian Mortimer and Matthew Page of Guinness Atkinson.

To be clear, I’m not saying that growth investing is worthless. What I want you to understand is that simple mathematics can give you a tremendous advantage in widely varied market conditions when it comes to income under conditions as varied as a World War, multiple regional conflicts, expansion, contraction, recessions, and more.

Which brings me back to REITs.

Most REITs are publicly traded entities that make money through their investments in real estate that are usually a combination of income-producing properties. Think shopping centers, retail strip malls, offices, warehouses… all the usual stuff. They can be private or non-listed, too.

Originally created by Congress in 1960, REITs are intended to provide a structure that, for all intents and purposes, is similar to a mutual fund. They’re typically broken up into two groups – so-called equity REITS and mortgage REITs.  At the start of 2016, there were more than 200 REITs in the U.S. that trade on a major stock exchange – most of them found in the NYSE.

REITs have to return 90% of their profits back to shareholders in the form of dividend income which is, of course, why they are so popular during low-rate regimes, and why so many people think they’re going to tank as rates rise.

Not All REITs Are Created Equal

Mortgage-based REITs – that is those investing mainly in agency-backed securities – are going to come under the most pressure when rates rise. That’s because the value of the fixed income investments they hold will decrease as rates go up. The reason is that yields of existing holdings will match or be inferior to newly issued alternatives with higher coupon rates.

Equity-based REITs – those investing in income-producing properties – are less sensitive to increasing rates. That’s because there’s usually plenty of cash flow AND appreciation to offset any price drop associated with higher rates. Not always, mind you, but enough that it’s a good rule of thumb.

Well-managed REITs that have a good handle on their debt won’t necessarily face higher interest costs like many people believe. Moreover, they may also be able to grow their revenues faster because of their ability to increase rent for the right tenants even in a rising rate environment.

A bond’s coupon rate, by comparison, can never change. That’s why bonds fall in value when rates rise like they are now.

Tap into one of more of our Unstoppable Trends and what I’m talking about takes on an entirely new dimension.

Let me explain.

Take Alexandria Real Estate Equities Inc. (NYSE:ARE), for example.

The company deals heavily in tech real estate in New York and San Francisco among other places, and I recommended it to Money Map Report subscribers months ago as a way to play the Silicon Valley boom while avoiding the risk of flashy startups.

It taps into the explosive Unstoppable Trend we call Technology using a very innovative “cluster model” that groups investments immediately adjacent to world class academic, medical, and technology institutions. The model exploits the logical strength associated with the world’s most sophisticated biotech companies, medical researchers, product development and even biofuels – all of which are highly secure lessees, not the fly-by-night, perennially unprofitable tenants associated with lesser quality REITs.

ARE has returned 20% since we recommended it to Money Map Report subscribers at a time when REITs were largely been on the decline. More importantly, though, it’s hiked its dividend payout by 22% since we recommended it.

Or, consider Omega Healthcare Investors Inc. (NYSE:OHI).

The Maryland-based company invests heavily in hospital properties and health care facilities, with a special emphasis on nursing facilities. In fact, it recently acquired Aviv REIT, another significant player in assisted-living.

OHI’s nursing home concentration dovetails nicely with two Unstoppable Trends, Medicine and Demographics, at a time when an estimated 10,000 baby boomers retire each day in America.

Like ARE, OHI has high-quality tenants representing a fraction of the risk associated with traditional office or residential tenants. And like ARE, OHI recently raised its dividend, increasing it by 3.4% from last quarter and resulting in a mouth-watering current yield of 8.06% according to Yahoo!Finance.

Moreover, it’s one of those special REITs with the wherewithal and management acumen needed to raise its dividends to shareholders quarter after quarter, not just once a year.

OHI Dividend History

OHI is cheap after the haircut so many REITs have seen in 2016, and it currently trades at a PE ratio of just 19.9, which strikes me as great value for a company that’s expanding its holdings and growing earnings by 11% year-over year at a time when so many companies are still fighting to emerge from the six-quarter earnings recession.

In closing, we’ve covered a lot of ground today and I hope I’ve made my point – the “right” REITs are not the investing zombies many investors think when it comes to rising rates.

Some, like the two I’ve recommended may even be superstars because they line up with our Unstoppable Trends.

Until next time,


Keith

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