REITs are suddenly no longer the hottest property on the block.
A spectacular six-year run sent the MSCI US REIT Index (RMZ) soaring by nearly 350% including dividends. In 2014, the index jumped by 30% thanks to investors scrambling for yield. The average U.S. REIT has a yield of about 3.5%.
But now, REITs may be on track for their worst year since 2008. The Vanguard REIT (NYSE:VNQ) is down 5% year to date, thanks mainly to fears over the Federal Reserve raising interest rates.
Making matters worse is a slowdown in China that’s driving fears of a global growth slowdown. For example, Chinese investors have been responsible for 30% of New York City’s foreign real estate transactions.
Understandable Fed Fear
The concern over what the Fed is doing is understandable. Since the 2008-09 financial crisis, 10-Year U.S. Treasury yield and REIT stock performance have had a strong negative correlation.
In other words, when the 10-year rate fell, REITs did well, and vice versa.
If the Federal Reserve raises rates too much, the economy could slow down drastically, resulting in falling occupancy rates. That would lower rental income, which in turn could affect payouts.
Additionally, REITs that are leveraged would also feel the adverse effects of Fed tightening. During the financial crisis, leveraged REITs had difficulty borrowing funds. This affected their ability to buy properties on the cheap and led to underperformance during both the downturn and the recovery.
Overblown Fed Fear
However, the current fears over interest rates seem overdone. In fact, it seems REIT investors have already factored in a number of rate hikes from the Federal Reserve that’ll likely never materialize.
I’m in the same camp as Ray Dalio, Founder of the $160-billion hedge fund Bridgewater Associates. He likens the current period to that of 1936-37, when the Fed raised rates a smidgen before reversing course.
Dalio thinks, at most, we’ll see a small tightening or increase in interest rates – although even that is in question now, with the Fed refusing (again) to raise interest rates at its September meeting.
Dalio then expects a fourth round of “quantitative easing,” with the Fed buying bonds and perhaps other financial assets. My colleague, Alan Gula, even pointed out that negative interest rates may be in our future. That’s where you pay the bank to hold your money.
REITs to Benefit
In my view, significantly higher interest rates are nothing more than a fantasy. Financial markets are too “addicted” to near-zero interest rates and the flood of money from the Fed (QE). Interest rates will likely stay low for a very long time, and this should benefit REITs and REIT investors.
As the old adage states, “In the land of the blind, the one-eyed man is king.”
With the Fed blindly keeping rates near zero, any financial instrument – like REITs – offering a half decent yield should do well.