The Right Time for REITs?

By: Nancy Zambell
Editor of Investment Digest and Dividend Digest

The Right Time for REITs?

I’ve always retained a few Real Estate Investment Trusts (REITs) in my investment portfolio—through bull and bear markets, through good and bad economic cycles and through periods of rising and falling interest rates.

There are a lot of reasons to like REITS. They offer:

• High income—as long as you choose a fundamentally strong REIT with a history of consistent payouts, you can count on some hefty dividends, currently averaging about 6%, but with a wide range from 1.5% to 15%. That kind of income is nothing to sneeze at.

• Portfolio protection—REITs in your portfolio can help protect your returns if the stock market corrects, as they often trade independently of the market.

• Diversification of assets—pooling your funds with thousands of other investors allows you to participate in a selection of real estate properties that you probably wouldn’t be able to purchase—or afford to maintain—on your own.

• Liquidity—it’s a lot easier to sell shares of your REIT than it would be to sell a home.

Those advantages to buying REITs hold true, no matter what stage the economy or markets are cycling through. But right now, there’s another reason to add REITs to your portfolio—one that doesn’t come around as often as I would like, but when it does—the profits can be spectacular!

REIT Prices have been Dragged down by Fears of Tapering

The following chart shows that the NAREIT Index rose as high as 180 in April 2013, but has fallen to about 160 currently. The catalyst behind the fall is simple—the Federal Reserve’s tapering of its bond purchases.

Last fall, market soothsayers began sounding the alarm—saying that the Federal Reserve had to begin tapering—followed by dire predictions about the market direction. That prompted some selling in REIT shares. And in December 2013, the Fed did announce its decision to “taper” the program, reducing it by $10 billion, to $75 billion per month. Then, on January 29, the Fed further reduced its purchases, to $65 billion a month.

But by the time of the January announcement, investors decided that REITs had perhaps been beaten down a bit too much, and, as you can see from the chart below, began coming back into the sector, pushing prices up a bit.

I think this prolonged dip has brought the group to attractive levels. In fact, as the following long-term chart shows, the group is still in the middle of its multi-year range.

What that means for REIT investors is that it’s time for a potential double-dip opportunity: fabulous dividends and the potential for some very good appreciation in REIT shares.

With this opportunity in mind, I ran different types of REITs (equity, hybrid, and mortgage REITs) through my model, and I’ve come up with an interesting pick, a mortgage REIT. The performance of this particular segment of the REIT market has suffered more than others because of a common market misperception, which provides a very good window of opportunity for investors… 

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Rising Interest Rates Lead to Poor REIT Performance

That’s just not true in most scenarios. Sure, if rates rose steeply overnight, you can bet that REITs would decline due to fear of economic catastrophe and a market rout.

However, when interest rates increase, they generally do so a little at a time, which, historically, does not create havoc in the REIT market.

There’s plenty of empirical evidence. An April 2013 study by Cohen and Steers reported:

• REITs have generated an annual return of 12.6% over the six monetary tightening cycles that have occurred since 1979.
• Over an equal number of periods when U.S. Treasury yields were rising, REITs generated an annual return of 10.8%.
• During monetary tightening from June 2004 through June 2006, when the federal funds rate was hiked 17—from the post-recession lows of 1.00% to 5.00%—the cumulative return of REITs was 57.9%, compared with just 15.5% for stocks.

The chart below gives you an idea of the superior returns that REITs have offered during periods of rising interest rates:

Mortgage REITs make their money by buying mortgages and then leveraging them by borrowing repurchase agreements against them. The profit is in the spread—the short-term rate they pay minus the interest they collect on the mortgages. The bigger that spread is, the higher their profit. And generally, the more leverage they employ, the more money they’ll make.

And right now, the spreads continue to be profitable, boding well for industry profits. There is also quite a bit of insider and institutional buying in the sector. Usually, that happens because these in the-know investors are putting their money where they think it will earn the most.

One REIT that has seen significant new purchases of its shares is Invesco Mortgage Capital Inc. (IVR)

CEO Richard King spent about $72,000 to add 5,000 shares to his holdings in December. That’s a great vote of confidence!

But even better, 26 new institutions have piled in, purchasing some 600,000 shares, and 86 existing institutional shareholders increased their holdings in Invesco by 8.2 million shares. They are obviously betting that the shares have hit their low and are gaining momentum.

The chart below supports this idea. The shares have crossed their 50-day moving average, and are progressing toward their 200-day moving average—a very good sign.

That momentum looks healthy, and with the real estate market continuing to gain traction, and credit becoming more attainable, I see no reason why the shares can’t move back to the $20 level again. Adding a dividend yield of 12.7% or $2.00/year to that appreciation, based on today’s closing price of $15.85 per share, would give you a 38.8% return—pretty healthy, considering the doldrums that the market has been in so far in 2014.

Of course, there are some risks that come along with such a high yield, including market and interest rate volatility, as well as the overall health of the real estate market. But as long as rates move up gradually, and the economy stays on track, this REIT may just help investors keep their double-digit returns alive in 2014.

Sincerely,

Nancy Zambell
Editor of Investment Digest and Dividend Digest

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