Everything seems to be going wrong for real estate investment trusts, or REITs. The Vanguard REIT ETF is down nearly 20% from 2012 highs. However, it may not be the right time to sell your investments in the sector. It could actually be an incredible opportunity for long-term minded investors.
The good times never seemed so good
In May of this year, the REIT industry was rapidly approaching historic highs. The Vanguard REIT ETF, which holds a broad array of REITs, came within several percentage points of all-time highs.
A key metric for the industry, the 10-year Treasury rate, was drifting under 1.75%, heading toward the 1.53% historical low. Such low interest rates allowed REIT companies to borrow money for virtually pennies and invest in new properties. Nothing seemed like it could derail the engrossing success of these Wall Street darlings.
The tides shift, rapidly
In mid-May, the Vanguard REIT ETF topped out near $80, and ever since then, it’s been falling. In just three months, the ETF has declined over 15%.
During the same days in which the REIT industry began to tumble, interest rates began to rise. Bottoming out at 1.66% on the 10-year Treasury early in May, interest rates have been rising ever since. The 10-year Treasury rate currently sits at 2.9%.
Why interest rates matter to REITs
Interest rates are paramount to REITs. Increases in interest rates heighten borrowing costs for REITs and hinder the industry’s ability to expand. In essence, higher interest rates make it more expensive to acquire properties and, in turn, cuts into profits.
Furthermore, interest rates indirectly affect REITs through the companies’ dividends. REITs are highly desirable for their attractive dividend yields and safe nature, acting as an alternative to bonds for many investors.
When rates rise, REITs’ dividend yields are forced higher as their yields must trade at a premium to yields offered by treasuries and other bonds to compensate for the additional risk associated with REITs. And the only immediate way to raise REITs’ dividend yields are to reduce the stock prices.
Where interest rates are heading
With interest rates being so vital to REITs’ future, investors want to know: Where are they heading?
Richard Clarida, global strategic advisor at PIMCO, believes rates will be lower at year-end than where they are at the moment. He says markets are pricing in that the Fed will reduce its asset purchases by $20 billion in both September and December, and anything lower than that will send rates plummeting.
Jessica Hind of Capital Economics, an economic research firm, forecasts the 10-year Treasury rate declining to 2.5% by year-end. She noted, “We think investors may have run ahead of themselves. After all, even if the Fed does start to scale back its bond purchases in September as we expect, interest rates will remain very low for an extended period of time.” The Fed has long said it will keep rates at ultra-low levels until unemployment hits 6.5%.
Opportunity is knocking
If the assumption that interest rates will remain historically low for an extended period of time is correct, substantial opportunities are presented in the REIT sector. Even the best-run REITs have been pulled southward with the overall industry. Realty Income Corp (NYSE:O), Ventas, Inc. (NYSE:VTR), Simon Property Group, Inc (NYSE:SPG), and Equity Residential (NYSE:EQR) are all leaders in their respective sub-sectors of the real estate market, pay out dividend yields above 3%, and possess a debt to equity ratio under 1, demonstrating the manageable size of the companies’ debt loads.
Furthermore, rising interest rates is not all bad for REITs. Rising rates are a traditional sign of improving economic conditions, which in turn would result in the companies’ occupancy rates rising.