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April 3, 2014

Authored by: Bill Zutter

In the last few years of near-zero interest rates, fixed income investors have had to look beyond bonds and have been driven by and large to the attractive dividend yields of REITs. Many investors mistakenly lump REITs in the same category as bonds, and sell them as interest rates rise.

For example, last May when former Federal Reserve Chairman Ben Bernanke announced the tapering of QE3, REITs reacted violently. The FSTE NAREIT US Real Estate Index shed 6.5 percent in that month alone, and limped along for the rest of 2013.  Though REIT holdings are more sensitive to interest rate fluctuations than other investments, rising interest rates are not all doom and gloom for REITs.

Interest rate risk is a common misconception among REIT investors. If an improving economy moves rates higher and GDP grows along with it, other fundamentals such as occupancy and rental rates will increase favorably as well.

Economists at NAREIT, the National Association of Real Estate Investment Trusts, have shown that there were 12 out of 16 periods since 1995 when interest rates rose and REITs also performed well. Nine of those periods even saw double digit gains. It should also be noted that REITs have outperformed the S&P 500 in 16 of the last 24 years.

After enduring a brutal 2013, REIT funds have mainly bounced back in 2014 and have outperformed the broader stock market, as evidenced by the 8.22 percent gain in the NAREIT All REIT index versus the 0.96 percent gain in the S&P through the end of February.  This bounce back is due largely to the overblown reaction in 2013 to taper talk and subsequent overselling.

In the coming months, REIT funds will be tested with rising interest rates; especially given the recent forward guidance of current Federal Reserve Chairman Janet Yellen. Of course some will fare better than others; those with better spreads of debt maturity and less exposure to short-term or variable rate debt will not be as adversely affected. REITS with shorter tenured leases such as hotel, industrial and multi-family are better positioned to keep up with changes in interest rates; whereas leases with longer tenure, such as mall and office leases, may react more negatively.

In sum, REITs are not for everyone but are a great way to gain exposure to commercial real estate. REITs are less than 10% correlated to the annual returns of US Bonds, thus it is not true that higher interest rates spell the end of high times for our beloved REITs.

Interested in learning more? Connect with Bill Zutter.

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