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Understanding the Three Rs: REITs and Rising Interest Rates

When the Federal Reserve suggested in June that they may consider tapering their massive, monthly bond buying program sooner than expected, market investors interpreted their optimism as a sign that interest rates would likely be rising in the short-term.  As weeks passed, investors came to the realization that this is not the case as economic growth and unemployment remain well below Fed target levels.  However, the damage in the Real Estate Investment Trust (REIT) sector was already done as REITs, as measured by the Dow Jones (DJ) Equity All REIT index, experienced a total return of -2.1% for the quarter – the weakest quarterly return for the index since the third quarter of 2011.  The DJ Equity All REIT index components include publicly traded companies in the S&P Dow Jones Indices U.S. stock universe that have elected to be taxed as REITs and are classified as Equity REITs according to the Dow Jones REIT Industry Classification Hierarchy.

Since the end of June, REIT performance has rebounded to a degree.  The same index cited above; DJ Equity All REIT index, has returned 3.33% through August 14, 2013 on a total return basis since the index hit its most recent bottom on June 20, 2013.   The rebound was even more significant through July 23, 2013, when the total return change since the June 20 bottom was over 11% until it pulled back to its current level of 1,154.31 on August 14.

Dow Jones (DJ) Equity All REIT Total Return Index

Date

Closing Level

% Change

6/20/2013

1117.13

7/23/2013

1241.55

11.14%

8/14/2013

1154.31

3.33%

Source:  Marketwatch.com, for the time period 06/20/13 – 08/14/13.  Past performance is not an indication of future results.  You cannot invest directly in an index.

I believe that this recovery was due to the belief that REITs will still likely perform well, on a price and dividend basis, through the balance of 2013 because economic growth and private job creation in the U.S. will not be robust enough to cause the Fed to even consider raising interest rates this year.   It is worthwhile to remember that Ben Bernanke, Chairman of the Fed, is still on record as suggesting that the Fed will likely retain an accommodative stance with respect to interest rates until the middle of 2015 – a point in time when their forecasts had suggested that their economic growth, employment and inflation targets would be met.  While this timeframe may be moving forward, I do not believe it is anywhere close to imminent.

I also believe that when the Fed does start to raise interest rates, they will do so on a measured, prolonged basis, with single period increases of no greater than 25 basis points (i.e. 0.25%), similar to the coordinate tightening program that the Fed implemented during the timeframe of June 2004- June 2006, when they increased the federal funds rate 17 times, in 25 basis points (Bp) increments, over this two year time period.

 

Date

Fed Funds Rate Change

6/30/2004

0.25%

8/10/2004

0.25%

9/21/2004

0.25%

11/10/2004

0.25%

12/14/2004

0.25%

2/2/2005

0.25%

3/22/2005

0.25%

5/3/2005

0.25%

6/30/2005

0.25%

8/9/2005

0.25%

9/20/2005

0.25%

11/1/2005

0.25%

12/13/2005

0.25%

1/31/2006

0.25%

3/28/2006

0.25%

5/10/2006

0.25%

6/29/2006

0.25%

Source: Federal Reserve Bank of New York, Historical Changes of the Target Federal Funds and Discount Rates, 2004 – 2006.

Such a drawn-out program should not put a significant dent into the pace of the economic recovery or the housing recovery.  With respect to the latter, while an increase in interest rates will affect short term borrowing costs of institutional investors and long term borrowing costs, and refinancing activity, of retail investors, the underlying momentum in the real estate market, coupled with the growing stability of the U.S. economy and increased purchasing power of the U.S. consumer, should be able to withstand these rate increases and prevent any significant price declines.   Positive housing market trends in terms of pricing, volume, inventory and sentiment continue across the country.    As a result, housing should remain as one of the noteworthy drivers of the U.S. economy and likely be an engine of future growth for the current “plow-horse” state of the U.S. economy.

I am not suggesting that there aren’t more challenging days ahead for REIT investors because there are.  With this said, it is critical for investors to understand the different types of REIT investments available and how these investment categories would react in a rising interest rate environment.  It is also important to understand the interest rate sensitivity of each of the REIT investment strategies.   For example, one would believe that one category of REITs; Mortgage REITs, might suffer the most if interest rates rise significantly following the rationale that the Mortgage REIT borrowing costs would increase in the rising rate environment and thus cut into the return and dividend potential of these types of REITs.  However, following this example, it would predominantly be increases in short term interest rates, not necessarily long term rates, that would impact the short term borrowing costs of the REITs.

As a point of contrast, other REIT categories that are either not as affected by movements in interest rates, or potentially stand to benefit from rising interest rates, include, but are not necessarily limited to, Self-Storage REITs and Apartment REITs.    Self-Storage REITs look to take advantage of the growing attraction to storage solutions across America through names such as CubeSmart, Extra Space Storage, Public Storage and Sovran Self Storage.  These REITs are not highly correlated to the housing market or sensitive to interest rates in general.   Apartment REITs, on the other hand, may stand to benefit from increases in interest rates as mortgage financing becomes more expensive driving some individuals from house ownership consideration to apartment rental consideration.   These two REIT categories delivered positive total returns for the second quarter of 2013 as the DJ U.S. Real Estate Self Storage index gained 2.3% and the DJ U.S. Real Estate Apartments index rose 3.5% for the quarter – despite fears over rising interest rates that surfaced during the month of June.

There are many REIT categories, such as Industrial/Office, Hotels, Regional Malls, Health Care, Strip Malls, Self-Storage and Apartments also present investment opportunities for investors who seek to have an allocation to real estate in their investment portfolios.   However, all categories of REITs contain their own set of unique risk factors that should be thoroughly reviewed and analyzed before considering an investment.

For these reasons, we, at Hennion & Walsh, have long been believers that investors should employ experienced portfolio managers, where appropriate, in asset classes such as REITs, within a well-diversified overall portfolio strategy that is managed in conjunction with a trusted, professional financial advisor.

Disclosure: Hennion & Walsh Asset Management currently has allocations within its managed money program and Hennion & Walsh currently has allocations within certain SmartTrust® Unit Investment Trusts (UITs) consistent with the investment strategies reviewed above. In particular, preferred stocks from Public Storage are currently held within the SmartTrust, Adelante REIT Growth and Income Trust, Series 1 and the SmartTrust, Adelante REIT Growth and Income Trust, Series 2. This posting is provided for informational purposes and is not a solicitation to buy or sell any of the investment strategies or companies discussed.