5 Reasons Not to Run From REITs During Rising Interest Rates

If you’ve been investing in Real Estate Investment Trusts (REIT) to seek competitive yields and income in the historically long 0% interest rate environment, you’ve probably been thrilled with the returns in this sector over the past 12 months. But while real estate investment trusts handily outperformed the S&P 500 index in 2016, times are changing fast. In the wake of a growing economy, many advisors are wondering where to turn to maintain yield as rates continue to rise. The yield on 10-year Treasury securities is up from 1.37% last July to over 2.50% as of March 17th, which makes fixed-income a challenging play. And with equity prices reaching all-time highs, they present a similar challenge. And while REITs may be the last place you may turn to seek yield in a rising rate environment, if suitable, they just may be the answer you’ve been looking for. How can that be? While REITs are often seen as interest-rate sensitive, rates don’t tell the whole story. Not by a long shot.

Here are five reasons why we believe simply shifting your strategy , but not running from REITs, may provide desired yield—even in the face of yet another rate hike:

1. REITs aren’t as sensitive to interest rates as it seems.

Conventional wisdom tells us that most income producing assets are sensitive to interest rate changes; as rates rise, their prices fall and vice-versa. But REITs are much more complex. In general, interest rates rise during a strong economy. That means that while higher short-term rates may have a negative impact on the cost of real estate debt, the benefit of a stronger economy may outweigh the drawdown caused by slightly higher interest rates.

2. REITs in a strong economy.

We believe, it’s the economy—not interest rates—that dictate the profitability and yield of REITs. A stronger economy may create greater opportunity for income generation from each property contained within a REIT. Real estate is more likely to appreciate due to greater demand. Plus, higher employment rates drive higher occupancy rates. In turn, higher occupancy rates support higher rents, which result in greater profitability and an increase in payouts to investors.

3. Large cap REITs aren’t the only game in town.

When most investors think about REITs, they immediately think of large, well-known REITs that focus on retail malls, huge office buildings, and properties leased to single, large, big-name tenants (think Walmart and Costco). What they tend to overlook are small cap REITs that can offer much greater diversification. Rather than focusing on big names and high volumes, small cap REITs include properties such as medical buildings and hospitals, storage facilities, smaller office and retail spaces, hotels, mortgages, and other specialized properties. This diversification is good news for anyone seeking to reduce risk in a shifting market.

4. Small cap REITs can have less sensitivity to the market.

Compared to large cap REITs, small cap REITs historically offer competitive yields with similar levels of volatility. For example, during the “Taper Tantrum” in 2013, investors panicked and pulled their money out of the bond market. As a result, 10-year bond yields jumped over 100 bps from 1.59% to 2.96%¹. Large cap REITs had modest positive returns over this period with a price change of 7%². But small cap REITs? According to recent research³, during the same period, the return on small cap REITs was sharply positive with a price change of over 25% during this period of rising rates. This despite almost a doubling of the yield on the 10-year U.S. Government Treasury bond.

5. Small cap REITs has demonstrated greater potential to capture yield in a high interest rate environment.

According to the Bloomberg RETI Small Cap Index and Bloomberg REIT Large Cap Index, small cap REITs were up nearly 2% while large cap REITs lost -4% in the fourth quarter of 2016 amid the backdrop of rising rates in the post-Trump election environment that saw 10-year yields jump from 1.6% to 2.4%. We believe REITs can benefit in a growing economy, but while rising interest rates can dampen yields for large cap REITs, small cap REITs have demonstrated the opposite effect. Since interest rates began to rise last summer, returns on small cap REITs have risen as well⁴. With the Fed expected to continue on the path of hiking rates to support a growing US economy, small cap REITs may provide a tool to capture yield just when you need it most.

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1. Source: Bloomberg as of 3/15/17.
2. Source: Morningstar as of 3/15/17.
3. Journal of Property Investment & Finance.
4. Source: Morningstar as of 3/15/17.
IndexIQ ® is the indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of the IQ Hedge Multi-Strategy Plus Fund. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC. Sal Bruno is a registered representative of NYLIFE Distributors LLC
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