REITs and rising rates: Pushing against conventional wisdom

By Stan Choe
AP Business Writer

NEW YORK (AP) - Are real-estate mutual funds going to see a price drop?

Real-estate investment trusts have been on a tremendous run since the financial crisis. Their returns have surpassed the broader market since early 2009, in part because the relatively big dividends they pay looked increasingly attractive as interest rates fell year after year. Now, though, the economy has gained momentum, and the Federal Reserve looks ready to raise interest rates later this year from their record low.

Conventional wisdom says rising rates will mean pain for real-estate investment trusts, or REITs, which own apartment buildings and shopping malls and pay out at least 90 percent of their profit as dividends. Not only would rising rates push investors to dump REITs and other dividend-paying stocks to go back to bonds, they would also raise expenses for REITs.

That conventional wisdom is a misconception, fund managers say. As long as the economy is improving, REITs can charge higher rents for their hotels, self-storage units and other properties and increase their profits and dividends. That should help them offset the effect of rising rates, and that's what happened in 2004-06, when the Federal Reserve was last raising rates, and in other periods.

But the managers also understand that the conventional wisdom is deeply ingrained and that some investors will reflexively sell REITs when rates are heading higher. The question is whether the selling will be enough to cause a sharp drop in prices, at least for the short term.

"There is an element of groupthink out there," says Mark McAllister, co-manager of the ClearBridge Tactical Dividend Income fund. "People think, 'The Fed is raising rates, it's time to head for the hills.'"

Earlier this year, it looked like a big downturn may be on the way. A strengthening job market was raising optimism that the economy was hitting a higher gear and expectations that the Federal Reserve would raise rates.

That sent equity REITs on a six-week losing streak, their longest in nearly five years. Investors pulled nearly $1 billion from one exchange-traded fund that tracks REITs in February alone.

But the momentum shifted in mid-March, after the Federal Reserve indicated it may raise rates at a slower pace than many had been expecting. REITs rebounded and had their best week in more than three years, though they have since given back some of the gains.

"They've gotten a reprieve," says Tom Kolefas, manager of the TIAA-CREF Mid-Cap Value fund. He owns a mix of REITs in his fund, but less than the index he uses as a benchmark. "People are saying, 'OK, rates aren't rising tomorrow, and you know it's not so bad."

Looking ahead, some real-estate managers do see the possibility for a big shake-up coming. At the Forward Select Income fund, for example, Portfolio Manager Joel Beam has traditionally been so optimistic that he usually borrows money to invest even more heavily in REITs to boost its returns.

But starting in the middle of last year, Beam cut back the borrowing, sold some of his holdings and built up cash so that he has some ready in case prices drop. REITs returned about 30 percent last year, and Beam says he's the feeling the most cautious about the market since the fund was established in 2001.

"I am worried about things being priced to perfection," he says. If prices end up dropping steeply, he says, "I want to be the guy with the money."

Other fund managers say REIT valuations look closer to fair today than expensive, although most acknowledge that REITs certainly are not cheap. They also say that the market has more experience now dealing with rising-rate jitters.

"I don't expect there to be a panic," says Jason Yablon, global portfolio manager at Cohen & Steers, which specializes in real-estate securities.

Although REIT prices will likely fall on interest-rate worries, Yablon doesn't expect any drop to be as severe as what happened during the "taper tantrum" in 2013, when there was much more uncertainty about when interest rates would rise.

At that time, investors were worried about the Federal Reserve pulling back on its bond-buying program and when that would lead to rate increases. Nearly two years later, most investors are in agreement that the Federal Reserve will raise rates sometime later this year, and the question is merely which month.

In the meantime, Yablon like other managers has been focusing on areas of the REIT market that benefit from an improving economy and are better shielded from rising rates. Apartment buildings can raise rents relatively quickly, for example, and apartments are in demand given more young adults are delaying marriage and remaining in cities.

"It's the economy that matters most," Yablon says, "not interest rates."

Published: Mon, Apr 20, 2015