A Real Estate Investment Trust (REIT) is a corporation, trust or association that owns and, in most cases, operates income-producing real estate and/or real estate-related assets. Modeled after mutual funds, REITs pool the capital of numerous investors. This allows individual investors to earn a share of the income produced through commercial real estate ownership, without having to go out and buy or finance property or assets. “REITs offer important benefits to investors and to property owners alike,” said Joe Mansueto, Chairman and CEO, Morningstar. “They allow investors to easily access real estate investments, and to do so with daily liquidity, diversification and broad choice.”

For the first half of 2013, equity REIT returns increased by 17.6%. On May 22, however, REITs took a big hit – declining by 13.5% over the next five weeks – when Federal Reserve Chairman Ben Bernanke suggested that the Fed’s $85 billion-a-month bond buying program would soon be tapered.

Despite continued improvement in the general economy, investors have been mostly bearish on REITs since Bernanke’s announcement. While REITs will face a number of challenges in 2014, one particular issue will be the focus of investors: rising interest rates.

REIT Basics

To qualify as a REIT, a company must have most of its assets and income tied to real estate investments and must distribute at least 90% of its taxable income each year to shareholders via dividends. These features help make REITs attractive to investors since they offer a highly liquid method of investing in real estate and typically boast healthy dividends. REITs typically offer better yields than other income alternatives – yields on REITs at the end of 2013, for example, were on average 3.8% compared to 2.6% for 10-year Treasury notes.

There are three basic types of REITs:

  1. Equity REITs – own and operate income-producing real estate (buildings and land). Revenues are generated primarily through rents (not by reselling properties). Ninety percent of REITs are equity REITs.
  2. Mortgage REITs – lend money to real estate owners and operators either directly through mortgages and loans, or indirectly through the acquisition or mortgage-backed securities (MBS). Revenues are generated primarily through the interest earned on mortgage loans.
  3. Hybrid REITs – use the investment strategies of equity and mortgage REITs.

The assets owned by REITs can include apartments, hotels, industrial facilities, resorts, self-storage facilities, shopping malls, timber-producing land, warehouses, and mortgages or loans. Regarding REITs that invest in mortgages or loans, Mansueto said, “[REITs] provide property owners with another way to raise funds, making real estate more liquid and transparent and allowing it to play a more important role in our economy.”

Many REITs in the U.S. are registered with the Securities and Exchange Commission (SEC) and are publicly traded on a stock exchange (most REITs in the U.S. trade on the New York Stock Exchange). These publicly traded REITs are considered very liquid assets, since they trade under substantial volume and investors can buy and sell them like stocks throughout the trading session.

There are also REITs that are registered with the SEC that are not publicly traded, as well as REITs that are neither registered with the SEC nor publicly traded. It should be noted, however, that non-exchange traded REITs are generally illiquid (extremely so in certain cases), valuation is complex, early redemption is often restrictive and fees can be substantially higher than exchange-traded funds. In addition, REITs that are not registered with the SEC are not subject to the same disclosure requirements, making it potentially challenging for investors to make informed decisions about the investment.

REITs and Interest Rates

Because REITs must pay out at least 90% of their taxable profits as dividends to shareholders, they make relatively high-yield instruments. REIT returns are based on dividends plus price appreciation, behaving similarly to typical small-cap stocks. Unlike these stocks, however, most of a REIT’s expected return stems from dividends rather than price appreciation. As a relatively high-yield investment, it is normal for REITs to exhibit sensitivity to changing interest rates.

Interest rates impact REITs for a couple reasons. First, debt is a fact of life for builders, developers and landlords, so they are highly sensitive to any changes in borrowing costs. Second, many investors are less likely to view REITs as attractive if their yields fall more in line with other securities like 10-year Treasury notes. “A quantitative analysis of REIT price movements shows that interest rates do matter to REIT investors – now more than ever,” said John Affleck, a research strategist with CoStar, a commercial real estate information company.

David Toti, a REIT analyst at Cantor Fitzgerald, agrees that REITs are sensitive to interest rate changes. “Over the past five years, many investors have moved into REITs as bond substitutes because the world has been desperate for yield in a zero-rate environment,” said Toti. “As rates begin to rise, if and when that happens, it makes these securities less attractive from a yield perspective.”

Unfounded Concerns?

While REIT investors did an about-face following the Fed’s tapering announcement, some industry experts say all the attention surrounding interest rates and REITs is unfounded. “Ever since May 22, there’s been this discussion about the role of interest rates in REIT returns – and it’s a very strange discussion,” said Brad Case, VP of Research with the National Association of Real Estate Investment Trusts (NAREIT) in a recent interview with CoStar News. “Because the truth is, when interest rates go up, it usually means the economy is strengthening. That’s good news for REITs and means that returns will be strong.” In support of this statement, Case pointed out that REITs have performed well in 12 out of 16 periods of interest rate increases since 1995.

REIT pioneer Sam Zell, brought up an interesting point at the REITWorld conference held in San Francisco in November. “Low interest rates make it possible to borrow cheap money and overpay for all sorts of bad investments,” Zell said. “Five or six years after the era of pretend and extend, a lot of overleveraged property still hasn’t been resolved. We would be much better investors and operators if there was a consequence for failure to act. When interest rates are 3% or 2% or 1%, you have no sense of urgency.”

What to Expect in 2014

While there is controversy regarding the degree to which interest rates affect REITs, Affleck pointed out that investors need to consider more than just how REITs perform when interest rates change. “The relevant measure is not whether REITs have done well during interest rate increases, but how they performed relative to the broader market,” Affleck said. “On that count, the data are definitive – REIT performance relative to the broad market is inversely related to interest rate movements.” Affleck added that REITs outperformed the broad market – gaining 27% compared to a 20% gain for the S&P 500 – when interest rates fell from 3.5% in March 2011 to 1.5% in April 2013.

Regardless of the effect of interest rates on REITs, it’s important to be mindful of the fact that REITs are not a one-size-fits-all investment, and that investment strategies vary widely across the REIT space. Apartment REITs, for example, may be well-positioned for growth in 2014. “Depending on your view of the economy, underemployment should improve over time,” said Jeffrey Langbaum, senior REIT analyst for Bloomberg Industries. “All those twenty-somethings living with Mom and Dad will be more prone to go out there and rent.” Because of a decline in starts and permits in multifamily rental units, Langbaum explained there’s little chance that supply will outpace demand over the long term – and that will give landlords more room to increase rents.

Healthcare REITs like nursing-home and senior-housing operators also may be poised for a strong 2014, backed by the aging population in the U.S., said Jenny Van Leeuwen Harrington, an income investing specialist who runs Gilman Hiss Asset Management. Triple-net-lease REITs, which own properties such as gas stations and standalone big-box stores, are another area Van Leeuwen Harrington likes. “Triple-net-lease REITs tend to have particularly stable businesses, with relatively limited growth upside, but relatively high, stable cash flows.”

The Bottom Line

“REITs present a great opportunity for both small and large investors to get exposure to the many areas of commercial real estate with liquidity and transparency in a diversified portfolio with relatively low leverage,” said Chris Mayer, Co-Director, Richman Center for Business, Law, and Public Policy at Columbia Business School. “While some investors worry about volatility of public markets, over the long-term REIT investments have performed quite well relative to their private market real estate counterparts while also limiting exposure to particular investment strategies or individual manger performance.”

When looking at REITs in 2014, it will be important to consider individual investments rather than making assumptions about the REIT sector as a whole. As Van Leeuwen Harrington pointed out, “REITs, I believe almost more than any other industry, should not be painted with a broad brush. There are so many sub-industries, each with completely unique characteristics, that sweeping statements can’t functionally encompass.”

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