It seems that Mr. Market is becoming more and more confused about Real Estate Investment Trusts (or REITs).
To be fair, there is some level of confusion since REITs have been on a feeding frenzy for years, driven primarily by historically low interest rates and record low construction levels. As in any cyclical investment activity, irrational behavior can always be displayed when there’s uncertainty, yet the fact that interest rates will soon rise is (as far as I’m concerned) predictable.
Of course, I can’t tell you exactly when the Fed will boost interest rates – I know it will occur as soon as market fundamentals validate such a move.
Nonetheless, Mr. Market seems to believe that REITs will somehow lose value as a result of rate increases (sooner or later). The reasoning though seems illogical – why would real estate securities lose value (falling share prices) when the underlying “brick and mortar” is increasing in value?
To answer that question, let’s examine the demand characteristics for REITs.
Remember that the reason that interest rates will soon increase is because the overall U.S. economy is improving, thus driving profitability. So, as demand conditions strengthen (in the U.S.), and assuming supply conditions remain normal (or below normal), REIT investors are likely to benefit from higher occupancy levels and stronger rent growth.
That supports the argument that rising rates are a net positive indicator – rising rents translates into rising dividends.
Because REIT income is driven by lease contracts with pricing power (the ability to pass along rising costs to customers/tenants) most should perform well in periods of rising inflation. Historically, REITs have been able to generate cash flow and dividend growth that significantly exceeds the rate of inflation.
So far in 2015 Equity REITs have returned around negative .41% (SNL US Equity REIT Index) while many leading blue chip REITs have grown their dividend payouts. It simply seems irrational to observe that the overall REIT health indicators – such a dividend growth – are improving, suggesting strong earnings performance, yet, Mr. Market is frowning.
