In a version of the Periodic Chart of Investment Returns by MFS Investments for the years 2001 to 2020, real estate investment trusts (REITs) were the top-performing asset class, on average, with a 9.71% average annualized return-edging out small- and mid-cap stocks.
Past performance, of course, is no guarantee of future returns. So, in the current environment, are REITs still viable investments for individual investors as well as financial advisors and their clients?
Interest Rates + REITS
The Vanguard REIT Index Fund (VGSLX), which tracks the MSCI U.S. REIT Index, has a current yield of 3.13% as of September 2021. In today’s low interest rate environment, this is certainly attractive to many investors. Rising interest rates are generally a negative factor for REITs; their outflows increase due to higher interest payments, which reduces the cash they have available to make dividend payments to investors.
REITs with excess levels of debt or those that need to refinance properties in the near term are more susceptible to a rate hike than others.
In 2018, for example, the price of the Vanguard REIT ETF (VNQ) is down more than 12% from a high in January of 2015 partly because of uncertainty over the Fed’s timing and willingness to raise interest rates.
REITs’ Past Performance in Rising Rate Environments
Cohen & Steers, an investment manager that offers a number of REIT funds, cites the Fed tightening cycle between June 2004 to June 2006 as an example of where the higher rates initially hurt the performance of REITs. But as time wore on, the strong economy then helped boost the return for REITs. The cumulative return for REITs over this time frame was 57.9%, which compares to 15.5% for stocks and 5.9% for bonds, according to the firm.
The firm suggests, “When the economy is improving and fundamentals are strong, yield-driven corrections have historically presented attractive buying opportunities for long-term investors. As the benefits of stronger economic growth have become more apparent, valuations tend to return to normal. We believe investors who are aligned to take advantage of these opportunities may be rewarded over the long term.”
REITs Offer Diversification Plusses
REITs are not a great diversifier from stocks as evidenced by their 70% correlation to stocks based on a comparison of the S&P 500 Index and the NAREIT Equity REIT Index over the 10 years through the end of 2020. REITs, however, do provide good diversification in terms of low or negative correlations to core bonds, commodities, and currencies.
Beyond interest rates, the performance of REITs will depend upon how the economy and the stock market fare. In a CNBC interview, Joseph Smith, chief investment officer for CBRE Clarion Securities, which manages about $22 billion in real estate assets, said: “there’s been a flip-flop going on between expectations for economic growth and interest rates. That uncertainty creates volatility, and in times of volatility, the correlation of REITs with the broader stock market increases.”
Recently, the COVID19 pandemic has created new risks and opportunities for the real estate market. Initially, shutdowns and quarantines forced many commercial businesses to close and job losses related to the pandemic left many unable to pay their rents. Government aid and stimulus, however, helped smooth some of this volatility. According to a 2021 report by Cohen & Steers, REITs are well-positioned into 2022 as analysts expect a global economic recovery. They write, “Just as COVID upended the REIT market in 2020, we believe it could be a prime beneficiary of a vaccine and a potential economic recovery.”
Factors Influencing Individual REITs
Like any mutual fund or ETF, there are underlying REITs in these funds. Individual REITs can include those that have an underlying portfolio of commercial properties, residential properties and hotels or resorts among many others. Additionally, there is exposure to specific sectors such as healthcare and specialty areas like timber and mortgage REITs.
The point here is that some of the performance of these REITs will be tied to the performance of the stock market and business sectors to which they are linked. This means that the performance of these REITs go beyond the performance of the overall stock market and/or the economy. This is not unlike the real estate adage that references how all real estate is local.
Individual REITs are also influenced by the people managing them. Like any other stock or similar instrument, management is important. What is their experience? Are they shareholder-centric? Do they have their own money invested alongside yours?
The Tax Cuts and Jobs Act of 2017 (TCJA) is advantageous to investors real estate. Some of the changes included in the new tax law affect REITs. For example, REITs benefit from the 20% deduction on pass-through entity income.
The Bottom Line
Like many other investments today, REITs may suffer at least initially from a period of interest rate hikes. REITs that are highly levered and those that may need to refinance debt while rates are rising may be more vulnerable than others. Those looking at individual REITs need to look at the management of the firm and its underlying portfolio of investments. There are a number of mutual funds and ETFs that provide solid exposure to this area as well. Over time, REITs have proven to be a solid component of many portfolios and may well continue to be going forward.