LOS ANGELES, Calif. – Like the rest of the stock market, real estate investment trusts have taken a beating this year and are well off their levels from a year ago.
The threat of a weaker economy has hurt, but REIT investors also have an uncertain outlook for interest rates to worry about.
Adam Patti, who oversees an exchange-traded fund focused on REITs as CEO of IndexIQ, thinks all this concern might make for a good time to buy REITs. REITs’ sharp fall after a big run-up about two years ago has made them more attractively priced, he says, and helped push dividend yields higher.
Patti believes that interest rate hikes won’t hurt REITs as long as the economy remains on firm footing.
Real estate investment trusts are companies that own real estate, like malls, apartment buildings, or commercial buildings. Unlike most companies, though, they operate under a tax structure that requires them to pay out most of their income, which is usually from rent and lease payments, to shareholders. Those high payouts make them attractive to investors seeking high yields.
But REITs also require a lot of money — and often debt — to operate. So when interest rates rise it drives the cost of borrowing up, which could translate into smaller dividends for shareholders. Rising interest rates also means that other income-generating investments, like bonds, start paying out more and attract investors away from comparatively risky investments like REITs.
The Federal Reserve raised its benchmark interest rate in December for the first time in nearly a decade and signalled the possibility of four more hikes this year. The outlook for further Fed rate hikes has been clouded in recent weeks by the financial markets’ turbulent start to the year amid jitters of a slowing global economy and a slump in crude oil prices.
Patti, who oversees the U.S. Real Estate Small Cap exchange-traded fund, makes the case for REITs despite their recent troubles. Answers have been edited for length and clarity:
Q: Why is now a good time to invest in REITs?
A: By getting in now, you’re getting into a secure asset class that has already been beaten down. In the case of (the US Real Estate Small Cap ETF), you’re getting about 5.8 per cent yield while you’re waiting for prices to recover.
And strategically, REITs generally are a good diversifier for your portfolio. I do counsel clients and prospects that you should have a strategic allocation to REITs generally.
Q: Which types of REITs do you anticipate will fare better given the state of the economy and job market now?
A: A lot of it has to do with the interest rate environment. We have seen strength in (apartment REITs). We’ve also seen strength in the office sector. The office sector in particular could continue to do well, assuming that the economy continues to slowly strengthen.
Typically, when the economy goes into recession, if that happens, then of course the office sector is going to be weaker. But (apartments) is a nice steady hand, kind of a ballast for the portfolio, because rents have been increasing pretty steadily.
Q: What’s in store for REITs given the uncertainty over when the Fed will continue raising rates?
A: If rates rise, what that means is the economy is on firm footing and that’s a positive for the REIT sector. Office REITs are going to do well as more businesses are going to need space. People are going to continue to rent. It goes across the board, across the economy.
Now, if the economy goes into recession, that’s a negative clearly on the REITs sector, but I don’t think we’re there.
We’re going to see additional rate rises, that’s my personal opinion. The Fed is going to act.
Q: Are share prices for REITs in danger of falling if the Fed raises rates?
A: A lot of that has been priced in, certainly at this point, given the Fed’s position on rates.
Q: Are REITs yields in jeopardy?
A: Yields are very robust now because it’s an inverse relationship with the price of the security. The security prices have come down so severely over the last 12 months that your effective dividend yield has gone up. So buying now you’re locking in a nice robust rate over the next cycle.