How Far Can The REIT Rally Go?

By Aaron Levitt | June 03, 2014 AAA

After having a terrible 2013, real estate investment trusts (REITs) have been killing it this year. Commercial property and mortgages have surged in the face of continued low interest rates and as investors shun traditional fixed income products for higher yielding options. As such, REITs like the iShares Real Estate 50 (FTY) have benefited immensely. Better yet, with the economy improving and rates still low, there's no sign yet that the REIT resurgence will end anytime soon.

Still Great Gains

At the end of the Great Recession, commercial real estate was a great place for investors to park cash. That was until the Fed signaled that it would begin winding down of its quantitative easing and bond buying programs in 2013. Investors indiscriminately sold off higher-yielding equities expecting them to suffer. Predictably, REITs fell hard and finished 2013 in the red.

But the expected rate rise has yet to materialize, and as a result, REITs have come roaring back. Since the beginning of the year, the sector benchmark – the MSCI U.S. REIT Index – has returned over 16%. Equities have returned about 2% over that same period. Similar gains could be in store for the rest of the year.

The first reason are those pesky interest rates.

Despite the slowdown of the Fed’s bond-buying program, the rate on the 10-year Treasury note has stayed relatively stable and even fallen to a low recently. At the same time, Fed Chairwoman Janet Yellen has pledged to keep short-term and overnight lending rates in the basement until the economy shows further improvement. Those rates are more closely tied to what fixed income investors receive on CDs, savings accounts and the like. As rates continue to be low, investors have plowed some big bucks into real estate-based equities for their safety and better returns. Already, 2014’s inflows into REIT-focused funds have surpassed 2013’s total.

Secondly, a strengthening economy benefits owners of commercial real estate.

Both office rents and industrial property rental rates and vacancies are tied directly to improving economic conditions. As the U.S. economy has improved, industrial properties saw the biggest single-year decline in vacancies ever. At the same time, office rent rates have increased. Green Street Advisors estimates that by 2018 rent rates for prime/core office space will have increased by 25%. Meanwhile, recent rises in consumer confidence and spending will continue to boost mall, strip mall and power center owners, while the lodging sector continues to see rising RevPAR numbers as demand grows among business and leisure travelers.

Getting Some Real Estate Exposure

With low rates persisting and a strengthening economy at their backs, the high dividends and share price growth REITs offer should be one of the best total return elements of 2014. Investors still have time to cash in on the sector. The easiest way is through the $41 billion Vanguard REIT Index ETF (VNQ).

VNQ tracks the previously mentioned MSCI REIT Index. That gives investors exposure to 131 different real estate firms, including office REIT Boston Properties Inc. (BXP) and mall operator Simon Property Group Inc. (SPG). VNQ’s broad scope also helps the ETF in the yield department. Currently, the fund yields a Treasury-beating 3.87%. And Vanguard's commitment to low prices helps VNQ’s expense ratio stay low (VNQ carries a 0.10% fee). Another choice is the iShares Cohen & Steers REIT (ICF), which invests in large real estate companies.

For investors considering direct bets based on the strengthening economy, hotel owners are often the last sector to see a bump making current valuations quite juicy. A solid pick could be RLJ Lodging Trust (RLJ). The firm focuses on strong hotel brands, such as Marriott International Inc. (MAR), and recently sold off several underperforming hotels. Analysts expect RJL’s FFO growth to rise 14% this year and 13% next year. Its shares currently yield 3.2%. Meanwhile, Hospitality Properties Trust (HPT) offers a similar portfolio and a 6.8% yield.

Finally, for those investors looking to profit from the low interest rate environment, mortgage REITs (mREITS) may worthy of your buck. This REITs don’t actually own physical properties, but the loans tied to them. There are countless varieties of mREITS, each with their own risks. The Market Vectors Mortgage REIT Income ETF (MORT) tracks a basket of these high yielders, such as Invesco Mortgage Capital Inc. (IVR). MORT yields a monster 13%. (For more on this topic, see Mortgage REIT ETFs: 10% Yields + Low Volatility.)

The Bottom Line

After spending much of 2013 in the dumps, REITs have roared this year. Investors should expect the gains to continue as long as the economy strengthens and interest rates remain low. (For more on this topic, see 5 Types Of REITs And How To Invest In Them.)

 

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