Interest Rates Are Preparing To Impact REITs

| July 13, 2011

REITs have enjoyed a long and extended run of low interest rate borrowing.  But it’s all coming to an end…

The Fed is tightening monetary policy and will look at raising interest rates sooner rather than later.  Fed Chairman Ben Bernanke has told us there’s no QE3 coming.  And their plan is to sell off the multi-trillion dollar portfolio the Fed currently owns as a start to the tightening process.  Rate hikes will follow shortly after, assuming the economy doesn’t tank.

Is this the signal to start pulling out of REITs?

I’ll answer that question in just a moment.  But first, I want to briefly explain what REITs are and identify the most common types of REITs.  Then I’ll show you how higher interest rates can impact the profitability of REITs.

And finally, I’ll tell you if it’s time to start selling your REIT holdings…

If you have REITs in your portfolio, then I’d expect you know what they are.  But if you’ve never heard of them, a REIT stands for Real Estate Investment Trust.  Each holds various real estate assets from homes, buildings, or mortgages.

REITs have gained in popularity because they trade like stocks or ETFs.  When you buy a REIT, you’re getting a piece of the pie versus a specific asset.

What really makes REITs attractive is they’re built to provide a strong income stream to shareholders.

In fact, they’re required by law to distribute 90% of their taxable income to investors as dividends.  Some of the dividend yields can get into the double digits!  The average yield on a REIT is currently around 4.1%.  For many investors, REITs make a compelling case for income.  Just compare it to your 0.5% savings account (if you’re lucky).

Now, the top two REIT categories include equity REITs and mortgage REITs.

Equity REITs are what you would traditionally think of when investing in real estate.  These funds buy up physical real estate assets.

Their primary goal, in most cases, is to collect rents and capitalize on appreciation of properties.  And equity REITs usually focus on a specific sub-group.  For example, a particular REIT can specialize in strip malls, apartment buildings, general residential, general commercial, or healthcare.

There are many, many more specialized REITs… but you get the point.

Mortgage REITs, on the other hand, are exactly what they sound like.  They buy up mortgages and collect the debt payments.  Most of these funds focus on purchasing both government mortgage backed securities (MBS) and private MBS.

But it’s how they make their money that’s important…

You see, all REITs now borrow money at record low rates.  But mortgage REITs take the cheap short-term loans and buy higher yielding long-term MBS products.  So, the difference between the rate at which they’re borrowing and the rate at which they are collecting is their spread.

It doesn’t take a rocket scientist to do the rest of the math…

If their borrowing cost rises, they’ll end up seeing their spreads tighten… which would reduce their profits.  As a result, they’d have less capital for dividend payouts.  And that’s one of the greatest risks of REITs… loss of dividend yield.

As I said earlier, because QE2 is over we’ll see higher interest rates in the future.  And the coming interest rate hikes will eventually squeeze the profitability of these funds.

Not surprising, the most sensitive to interest rate hikes are mortgage REITs.

While rising interest rates increase the borrowing cost for all types of REITs, the mortgage REITs have the most to lose.  Even worse, once a REIT starts to lose dividend yield, there will be a mass exodus from the REIT sending share prices lower along the way.  And that’s the last thing anyone wants!

So, we know rate increases are down the road… but is it time to sell your REITs?

Here’s the deal…

Equity REITs may be safe for quite some time.  It’s been proven that equity REITs are not as highly correlated with interest rates as mortgage REITs.  But all types of real estate funds are eventually affected by interest rate changes.

That said, most equity REITs have taken advantage of record low rates they’ve locked in for long periods.  So you may be able to hang onto these REITs longer than mortgage REITs.

And with mortgage REITs, the Fed’s given us a clue as to when it might be time to sell…

If you are holding mortgage REITs, you shouldn’t expect much of a drop in your dividend for the next three to six months.

Remember, we should see low interest rates “for an extended period”.  And deciphering Fed-speak tells us rates will stay stable for anywhere from three to four months.

But once the Fed finally signals for a rate increase, it may be time to cash out…

 

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Category: Real Estate

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