Like other high-dividend-paying stocks, REITs are largely sensitive to rising interest rates as their yields start to look relatively less attractive versus fixed-income alternatives. With rates again trending up, it could be a bumpy ride for the REIT market going forward.
It also might be a great opportunity to get into the real estate market.
“If interest rates are going up because the economy is improving, that can be positive for REITs because landlords can raise rents to cover the rate increases,” said Brian Cordes, a senior vice president at Cohen & Steers, an investment company focused on real estate. He expects the U.S. economy to grow by 2.9 percent this year. “We see the recent pullback as an attractive entry point to the asset class.”
For investors looking for income, the 4.5 percent average yield on the FTSE Nareit All REIT index is an attractive alternative to bond yields. REITs, however, are equities and carry equity risk. Dividend yields are not fixed, and they can and do fall — often dramatically.
Investors need to consider the total return picture for the investments rather than just the current yield, said Cedrik Lachance, director of U.S. REIT research at Green Street Advisors.
By several measures REITs do look cheap.
The unlevered total return expectation of REITs is currently 5.9 percent versus 4.6 percent yield on 30-year Baa-rated bonds — slightly tighter than the 150-basis-point historical average, according to Lachance. In other words, REITs look slightly overvalued on that front. They are trading 30 basis points lower than high-yield bonds versus an historical average of 60 basis points — suggesting slight undervaluation.
“REITs are not wildly cheap versus corporate bond alternatives, but they are somewhat attractive,” said Lachance.
They look better versus the rest of the stock market. REITs posted a respectable 9 percent total return last year, but that significantly underperformed the 21 percent return on the S&P 500 Index (dividends reinvested). Over the last five years, the price/earnings ratio on the Russell 3000 index has expanded from 15.2 to 21.9, while the multiple in the REIT market (based on funds from operations) has fallen from 18.9 to 16.4. “REITs posted similar earnings growth, yet their multiples contracted,” said Cordes at Cohen & Steers.