It Was Going to Be the Year of the REIT
2016 was supposed to be the year of the REIT -- until it wasn't.
In September, real estate got its own major market index category, bringing real estate investment trusts more visibility and, by extension, access to more capital.
Like clockwork, real estate-related ETFs saw their greatest inflow ever in September. But October saw steep outflows, due to investors' fondness for higher government bond yields and a greater likelihood of an interest rate hike. November’s seismic political shift exacerbated those conditions, making an interest rate increase almost inevitable and sending bond yields soaring further.
The election of Donald Trump and his attraction to a stronger dollar have helped spur higher rates, meaning, also, higher borrowing costs. That's a bad thing for REITs, which pay 90 percent of their taxable income as dividends and thus rely on debt for growth.
The specter of higher interest rates also caused a bond selloff and 10-year government bond yields to rise. Rising bond yields also make REIT yields less attractive to investors.
In turn, nearly all types of real estate investment trusts saw price declines recently, regardless of their underlying fundamentals. Total returns on the National Association of Real Estate Investment Trusts’ All Equity REIT index had surpassed the S&P 500 Index until November, when the S&P 500 pulled ahead. Recent price drops have offset some of REITs' long-term gains:
Retail and health care REITs have suffered the most lately. The retail businesses that underpin the former have long faced dwindling in-store sales and looming deadlines for debt repayments. Rising interest rates will only mean more pain for retail landlords, who may have trouble refinancing.
Health care REITs, for their part, are the most susceptible to rising interest rates. Their underlying leases tend to be longer term than other real estate leases, meaning property owners may not be able to raise rents fast enough to offset rising rates.
But not all is bad in REIT-land.
Single-family housing rentals have been this year's success story. Private equity real estate company Blackstone is set to make public its Invitation Homes holding, the biggest single-family housing landlord. The sector has received a boost from millennials delaying home ownership. Industrial REITs, thanks to sustained demand from e-commerce, have also had a stellar year. Their growth is expected to continue as same-day e-commerce delivery requires more industrial space in and around major cities.
In general, real estate fundamentals are strong. Demand for real estate of many types is high and rents for the most part are growing. A steady interest rate increase and competition from bond yields won't change that. In fact, an interest rate hike should signify an improved economy -- which will have a greater impact on REITs than rates. And NAREIT’s average dividend yield (4.47 percent) is still about 200 basis points higher than 10-year treasury bonds (2.53 percent), so that still makes them an attractive bet.
Growth is still on the horizon for REITs, as evidenced by a 9 percent increase in the amount of capital raised this year compared to last, according to data from financial analytics company S&P Global. As noted above, REITs pay out most of their profits as dividends to investors, so they rely on borrowing to expand.
So while 2016 caused some short-term pain for REITs, the sector's fundamentals suggest that it still has good long-term prospects.
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