A Hated High-Yield Investment Every Income Investor Should Love

Perception is reality, so we’ve been told.
It’s nonsense, of course.
Perceive you can fly, then take the elevator to the 102nd floor of the Empire State. Scale the security fencing, and then leap in full swan-dive glory. Let me know how perception and reality gibe.
Similar, if less hyperbolic, perception-is-reality nonsense pervades investing. Investors perceive one thing, reality is frequently the other.
Investors perceive equity real estate investment trusts (REITs) as risky. Perception has manifested in a real selloff.
Double-digit write-offs abound: The Vanguard Real Estate Index Fund (NYSEArca: VNQ), Schwab US REIT ETF (NSYEArca: SCHH), iShares Cohen & Steers ETF (NYSEArca: ICF), three of the more popular equity REIT investments, are down 10% or more, year to date.
Hate is a strong word, but investors are indifferent at a minimum. They shed REITs these days as willingly as a growing snake sheds its skin. But why?

Fear and Interest Rates

Interest rates are the issue. Investors fear higher interest rates. They perceive higher interest rates as bad for REITs.
Investors perceive an interest-rate risk because REITs are perceived as bond surrogates. Bond values frequently decline as an immediate response to rising interest rates. Higher interest rates reduce the present value of future cash flows. REIT dividends are perceived similarly.
REITs are also perceived as double-jeopardy investments because of their pass-through configuration.
REITs retain little earned income. A REIT can grow only by issuing new equity or debt. Debt is an imposing variable in the capital-structure of most REITs. Tapping debt markets to grow or to refinance maturing debt in a rising-interest-rate environment can crimp cash flows (and dividends).
A knee-jerk selling reaction with REITs frequently occurs when investors anticipate rising interest rates. The spasm frequently passes, though. Equity REIT prices recover soon after.
We’ve seen this price pattern with the aforementioned REIT ETF investments. They’ve sold off when investors anticipated rising interest rates. They’ve recovered in subsequent months, if not weeks.

Why Equity REITs Are Enticing

I’m unfazed by the perceived interest-rate risk. Equity REIT fundamentals remain strong. The opportunity to pick up high-yield income at a value price in quality REITs – equity REITs specifically  – is enticing. This is more than my perception.
Equity REITs are less sensitive to interest rates than investors perceive. Data gleaned from Nareit, an industry trade group, show that share prices of listed equity REITs more often increase during periods of rising interest rates.
In the 16 periods since 1995 when interest rates rose significantly, equity REITs generated positive returns in 12 of the periods.
Discrimination is key, though. All REITs aren’t built alike. Note that Nareit and I refer to “equity” REITs. These are REITs that own the real estate and the accompanying buildings that they lease to tenants.
Another REIT incarnation hides like a wolf in sheep’s clothing. I refer to mortgage REITs.
Equity REITs and mortgage REITs share a name, but that’s all they share. They are animals of a different species.
Equity REITs own physical real estate and buildings. Mortgage REITs borrow money to buy mortgages that back the physical property buildings. Mortgage REITs own the paper on the property, but not the physical property.
Mortgage REITs are financial entities. They’re highly leveraged. They borrow short term and invest in long-dated mortgages. Should short-term interest rates interest rise faster than long-term rates, the house of cards collapses.
All REITs are hated these days. Good for us.
Look to quality equity REITs, such as the aforementioned ETFs, or to select individual equity REITs (like the REITs we feature at High Yield Wealth). You’ll pick up income and yield – and I refer to safe yield as high as 5%, 7%, and even 10%. You’ll also pick up opportunity for significant share-price appreciation.
That’s REIT reality.

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