Interest rates are going up. The Federal Reserve has hiked the federal funds rate three times this year, with more likely coming after the calendar flips to 2019. Fortunately, there’s a way to combat rising interest rates.
As rates rise, you may consider a realignment in your portfolio, to take advantage of stocks that tend to do well during those periods. That includes utility stocks, which were the best performers during the October-November market correction; financials, which see margin expansion as rates rise; and consumer discretionary stocks, including automobile, retail (not necessarily the brick-and-mortar stores), restaurants and luxury goods.
But one sector that shouldn’t be discounted—but often is due to misinformation—is Real Estate Investment Trusts (REITs). Many investment pros sound the alarm on REITs in rising interest rate conditions, making investors fear not only the loss of generous dividends, but also potential stock collapses. That misconception is far from the truth.
REITs and Rising Interest Rates
Why? It’s based on the assumption that as rates rise, REIT profits will erode, and stock prices will decline. In theory, that looks right, as generally, when rates rise in a fixed income instrument like a bond, prices generally fall. And with mortgage REITs, that’s usually true. They are leveraged to the hilt, so rising interest rates will usually negatively impact their prices. But for equity REITs, that notion doesn’t prove out.
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The following graph was recently published in Forbes and shows a more complex picture. It plots monthly data over 10 years ending in mid-2017 between 10-year U.S. Treasury Futures and the MSCI US REIT Index (RMZ) and indicates that while there is some correlation between rate hikes and REIT price declines, the most significant correlation is when rates suffer a sharp hike. In contrast, with gradual rate increases, the correlation declined. That’s because gradually rising interest rates indicate an improving economy, and for REITs, that can mean rising rents and lower vacancy rates, which leads to more profits, and better stock prices.
For the investor, however, when rates begin to rise, REIT investors tend to panic, and that may cause REIT prices to temporarily slide—a buying opportunity, in my opinion.
So, the question is, which REIT categories will likely do just fine as interest rates continue to rise?
Three Types of REITs to Buy
I mentioned mortgage REITs a moment ago, and for the most part, they are not the investments to hold during rate increases. However, the same cannot be said for commercial mortgage REITs. That’s because they tend to borrow at fixed interest rates and lend at variable rates, so their borrowing costs remain fixed, but the lending income rises as rates go up. One to consider: Ladder Capital (LADR), which has a current dividend yield of 7.9%, and is rated ‘Buy’ in consensus analyst forecasts. One caveat, however, is that investors should be aware that rising rates can increase default rates which can lead to dividend cuts. Consequently, it will benefit you to keep a close eye on any commercial mortgage REIT that you own.
The charts below show REIT beta (measure of volatility) to the S&P 500, as well as to yields.
You can see that hotel REITs are the most volatile as compared to the S&P 500, which makes sense, as they are also very economically-dependent, but the least volatile when it comes to yield, and that’s because their cash flow is short-term. As long as the economy continues to improve, hotel REITs should also, as consumer discretionary buying rises. RLJ Lodging Trust (RLJ), with a yield of 6.65%, and a consensus rating of ‘Buy’ may be an interesting choice.
This REIT was recently recommended in my Wall Street’s Best Dividend Stocks by contributor Gray Cardiff, editor of Sound Advice. Here’s what Gray had to say about the REIT: “The company is on a mission to upgrade its assets by purchasing properties in high growth markets with barriers to entry while seizing opportunities to sell at high prices. Based on the latest trailing four quarters’ financials reported, and using a 7.5% cap rate to evaluate the company’s portfolio, we value RLJ at $43.16 per share, which is considerably higher than the current price. The high dividend yield is attractive and lowers the risk profile.”
Alternatively, Net Lease REITs show the most volatility to yields, which also seems right, as their long-term contracts—while inflation-adjusted—may not keep up with quick rate rises, but they are the least volatile, compared to the S&P, because they have long-term steady cash flow. But these REITs have been known for dividend safety, good steady income, with decent rates, so gradual rate increases shouldn’t bother them too much. Warren Buffett sure thinks so, and earlier this year, purchased a 9.8% stake in STORE Capital (STOR), which yields 4.45%, and carries an analyst ranking of ‘Buy’.
So, it’s obvious your investing decision in REITs is not just a function of beta. It’s a bit more involved. While rates and economic factors are important, investors must also pay attention to the fundamentals. That means a bit of research, including:
- Funds from operations (FFO): compare four quarters of FFO to the REIT’s annual dividend payments. That is the dividend coverage ratio, which should be more than 1:1, meaning the REIT is earning more than it pays out in dividends.
- Dividend track record—is it stable? Has the dividend been cut?
- Review the portfolio, including the vacancy rate history, credit ratings of its holdings, and diversification.
- Valuation of REITs is every bit as important as with any other stock. It’s best not to overpay; that way, you get the benefit of appreciation plus a handsome and steady cash flow.
If your REIT idea meets most of these criteria, exhibiting fundamental strength and value, then this may be an opportune time to add some steady cash flow to your portfolio.
For additional REIT investing ideas, I urge you to read my report, “Cabot’s 10 Best REITs to Buy Now.” It’s a list of my 10 favorite REITs to combat a rising-interest-rate environment, diversify your portfolio and build income with little capital.
To read the report, click here.
Nancy Zambell, Editor of Wall Street’s Best Investments, has spent 30 years helping investors navigate the minefields of the financial industry. Nancy scours more than 200 advisories and research reports to select the top recommendations, which she collects for you in this easy-to-read digest.Learn More
This post has been updated from an original version.