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March 22, 2015 at 09:59 AM
Real estate investment trusts (REITs) have turned in a solid performance recently.
The FTSE NAREIT All REITS Index has moved higher for each of the last six years, including a 27.2% total return increase in 2014. Plus, several REITs generated total returns over 60% for the year.
Several factors drove these results, including an improving economy and unexpectedly lower interest rates. Could the party be coming to an end?
The index increased 5.6% in January 2015 but fell by 2.6% percent in February.
While February’s drop certainly isn’t one of the index’s more volatile downside moves—it fell by over 8% between May and August 2013 on interest rate hike scares—it could reflect the consensus that rates will move higher in 2015.
This prompts the question: Will higher rates offset the benefits of continuing economic growth that’s helping many property types?
Business Outlook
If this concern over higher rates’ impact on REITs’ returns sounds familiar, you’re right. It’s popped up each time observers believe the Fed will finally start bumping up rates.
In July 2014, Matthew Werner, CFA and his fellow analysts at Chilton Capital Management in Houston, considered the risks facing REIT investors in their report, “This Bull has Room to Run: Why 2014 is Not Comparable to 2007.”
The report focused on interest rates and the underlying fundamentals: debt and dividend payout ratios, new property development and the spread between 10-year Treasury yields and REITs’ implied capitalization rates.
“Headwinds like higher interest rates could temporarily derail REIT total returns, but our positive forecast for the underlying properties has very little near- to medium-term risk in it,” the authors explained. In fact, higher interest rates will only help to further constrain new development, which would continue to tilt the supply and demand dynamics in favor of current landlords.”
Occupancy rates support the notion that most REIT sectors aren’t oversupplied.
According to a Citigroup report cited by the Wall Street Journal in late-December, fourth quarter 2015 occupancy rates across all the REIT sectors was a record-high 94.5%. Occupancy varies across the sectors, of course, but overall the country’s economic growth is benefiting property owners.
History Lessons
In the short term, of course, rate increases tend to hit REITs’ returns hard, and it’s not uncommon for the index to drop 5% or more in a month.
Still, even with the market accepting a likely interest-rate high in June, the FTSE NAREIT All REIT Index is up 1.4% in March (through March 19). That puts it ahead of all other major indexes, including the Nasdaq, which is up 0.6% in the same three-week period. (This is after the FTSE NAREIT index improved 5.6% in January, and then weakened 2.6% in February.)
