Real Estate Investment Trusts, commonly referred to as REITs, have been among the market’s best-performing asset classes for an extended period. For example, the SPDR Dow Jones REIT ETF (NYSEARCA: RWR), a proxy for REITs, has returned 10% year-to-date, while the S&P 500 Index is up 7% in the same time. Over the past two years, the REIT ETF has outperformed the market by seven percentage points. Including dividends, it has outperformed by an even wider margin.
The massive outperformance of many REITs can be attributed in large part to the search for yield. In this low interest rate environment, investors are starved for yield. Income investors have plowed into traditional high-dividend sectors like utilities, telecoms, and REITs, because these companies tend to pay higher dividends than most stocks.
However, with higher interest rates on the horizon, and valuations looking stretched, investors should consider repositioning their portfolios out of rate-sensitive sectors like REITs.
The Question of a Dividend Bubble
In a world of historically low interest rates, income is hard to find. Investors who want income, such as retirees, are in a difficult position. Since bond yields are so low, many income investors have been forced to buy dividend stocks. This has caused huge demand for dividend yield, but many REITs simply look overvalued right now.
Take Realty Income (NYSE: O) as a prime example. Realty Income has a devoted following among income investors because it has a rock-solid track record of steady dividends. Indeed, Realty Income has come through with 75 consecutive quarterly dividend increases. And, Realty Income has trademarked the name The Monthly Dividend Company, because it pays its dividend each month without interruption. In fact, Realty Income has paid an amazing 552 consecutive monthly dividends.
But Realty Income stock price has rallied tremendously in recent years, to the point where it could seriously be considered overvalued. At $68 per share, the stock is sitting at an all-time high. This matters because a rising stock price causes a dividend yield to drop, as price and yield are inversely related.
Realty Income currently yields 3.4%, which may still be viewed as attractive, but context is necessary. Realty Income’s dividend yield is at an all-time low. This stock typically yields above 5%. Investors are paying a higher price than ever, for less income than ever.
And, the dividend yields offered by REITs may seem even less attractive if interest rates are about to rise.
Sell REITs Ahead of Rate Hikes?
Last December, the Federal Reserve raised interest rates for the first time in a decade. The central bank has held off on raising rates again this year, in light of the global economic uncertainty presented by the Brexit vote and other macro-economic concerns, but it is likely future rate hikes are coming.
The Fed has kept two thresholds for raising interest rates—full employment, as measured by a 5% unemployment rate, and 2% inflation. The U.S. economy is likely to meet both of those marks by the end of the year. That is why many economists believe another rate hike is coming, perhaps as early as next month.
The implications for this are negative for REITs. Higher interest rates will raise the cost of capital for companies that rely heavily on debt to finance their assets, such as REITs. If interest rates rise, it will be more costly to take out debt to finance acquisitions of new properties, which is the main growth engine for REITs. With a higher cost of capital, earnings are likely to decrease.
If earnings are set to decline, investors will likely not be willing to pay such high valuation multiples for REITs. This could result in significant multiple compression, and falling stock prices, across the REIT asset class. There is no doubt that the last few years of historically low rates have been a boon for REITs, but the opposite environment will likely be painful.
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