It seems that Mr. Market is becoming more and more confused about Real Estate Investment Trusts (or REITs).
To be fair, there is some level of confusion since REITs have been on a feeding frenzy for years, driven primarily by historically low interest rates and record low construction levels. As in any cyclical investment activity, irrational behavior can always be displayed when there’s uncertainty, yet the fact that interest rates will soon rise is (as far as I’m concerned) predictable.
Of course, I can’t tell you exactly when the Fed will boost interest rates – I know it will occur as soon as market fundamentals validate such a move.
Nonetheless, Mr. Market seems to believe that REITs will somehow lose value as a result of rate increases (sooner or later). The reasoning though seems illogical – why would real estate securities lose value (falling share prices) when the underlying “brick and mortar” is increasing in value?
To answer that question, let’s examine the demand characteristics for REITs.
Remember that the reason that interest rates will soon increase is because the overall U.S. economy is improving, thus driving profitability. So, as demand conditions strengthen (in the U.S.), and assuming supply conditions remain normal (or below normal), REIT investors are likely to benefit from higher occupancy levels and stronger rent growth.
That supports the argument that rising rates are a net positive indicator - rising rents translates into rising dividends.
Because REIT income is driven by lease contracts with pricing power (the ability to pass along rising costs to customers/tenants) most should perform well in periods of rising inflation. Historically, REITs have been able to generate cash flow and dividend growth that significantly exceeds the rate of inflation.
So far in 2015 Equity REITs have returned around negative .41% (SNL US Equity REIT Index) while many leading blue chip REITs have grown their dividend payouts. It simply seems irrational to observe that the overall REIT health indicators – such a dividend growth – are improving, suggesting strong earnings performance, yet, Mr. Market is frowning.
Since the beginning of the Taper Tantrum (back in May 2013) REITs have become highly susceptible to the shear whisper of the words “rising rates”. Over the last two years we could have even predicted, to a high degree, when REIT shares would pull back based upon the various economic news (i.e. job growth, consumer spending, etc...).
Why the rush for the door?
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All have their own opinions and here’s mine. I believe that the Index Funds and various REIT ETFs are all behaving unreasonably due to their strong kinship with fixed-income products. While many REIT investors (including me) are described as the “buy-and-hold” type, the electronic traders are consistently spooked by any form of security that looks, feels, or even tastes like a bond (I’ll admit, I’m not sure what a bond tastes like).
These 'risk-free' investments (i.e., guaranteed return of principle + interest payments) will soon be competing with the high-yield equities and my theory (of the REIT selloffs) stems from the reasoning that the “electronic investors” have already begun switching their risk-free traits with the risk-free look-a-like ones.
Keep in mind, these fairly common hiccups in the REIT sector have also created a favorable environment for investing. Owning a REIT (or any similar security) with consistent dividend growth provides a favorable message that the company’s earnings potential is sound. Although the market may view the (REIT) sector in a less favorable light, the spotlight (for the
Several blue chip brands (referenced in my Forbes Real Estate Investor newsletter) with accelerated divided growth include Tanger Factory Outlets (SKT), Taubman Centers (TCO),
Reconciling the mood swings of Mr. Market is a complex matter and while I have aimed to simplify the market noise by providing fundamental reasoning to support the argument that REITs are sensitive financial instruments, there is no way that I can provide you with a crystal ball.
I’m not the Wizard of REIT-dom and it’s simply impossible for me to help you eliminate all investment risk. However I can provide you with the next best thing: Selecting securities with a significant margin of safety remains that value investor’s definitive precautionary measure.
Over the next few weeks and months, Mr. Market will continue to get whiffs of risings rates and then the day will come when the Fed pulls out the #1 utensil in the toolbox. Meanwhile, REITs have already demonstrated their uniquely skilled value – a utility differentiated by durability – that represents the best possible evidence of dividend safety. In the words, as Josh Peters (with Morningstar) explains, “the safest dividend is the one’s that’s just been raised”.
Disclosure: I own shares in SKT, TCO, VTR, OHI, WPC, ROIC, and STAG.
Brad Thomas is the Editor of the Forbes Real Estate Investor.
Source: SNL Financial, FAST Graphs, and The Ultimate Dividend Playbook
