It all started on May 22 when Fed Chairman Ben Bernanke announced that the central bank would begin slowing its bond-buying program. News of the “taper” created immediate fears that interest rates would soon rise. And while the Fed didn’t raise interest rates, the yield on the 10-year jumped.
But the ramifications of the taper reached much further than the bond market. Investors also began selling shares of companies with a big dependency on debt. The thought was that with yields rising, the cost of borrowing would increase and cut into profits.
REITs were especially hard hit. That’s because these companies own and operate properties including commercial office buildings, health care facilities, apartment buildings, shopping malls, hotels, and storage units. REITs issue debt to finance their purchase of properties that they then lease out.
Today investors believe that rising yields on Treasurys – and any future increase in interest rates – will be devastating for REITs. In reaction to the taper announcement, the Vanguard REIT ETF (NYSEARCA:VNQ) has fallen 15%. As a result, REITs have underperformed the S&P 500 by 25% since the taper was announced.
The truth is that most investors don’t have their facts right.
A research report from one well-regarded investment boutique found that REITs historically outperformed stocks and bonds during periods of rising interest rates or higher yields for U.S. Treasury’s.
Since 1979, there have been six periods of monetary tightening and rising U.S. Treasury yields. When U.S. Treasury yields are rising (as is happening now), REITs delivered average annual returns of 10.8%. And in periods when the Fed was actually increasing interest rates, they performed even better with a 12.6% average annual gain. Those returns were far superior to stocks or bonds over the same period of time.
In fact, even during periods of rising inflation, REITs have outperformed. And from 1974 to 2012, REITs delivered an average annual return of 14.1%. That’s well ahead of an 11.7% gain for stocks and 8.3% increase for bonds.
Today, the common wisdom about what’s ahead for REITs doesn’t match up with the historical record. This misconception creates an opportunity for investors who are willing to buck the trend.
Why do REITs do well even when interest rates are rising? There are two primary reasons.
First, hard assets back up REITs. These companies own properties that have tenants and generate cash flow. During periods of inflation, many investors want to own hard assets such as land and buildings.
Second, rising interest rates is typically a sign of a strong and growing economy. When the economy does well, there is greater demand for properties. As a result, REITs are able to raise their rental rates and increase their cash flow from their properties. This means that even if the cost to borrow capital rises, that increase can be offset by higher rents.
The long-term record for REITs is very strong. The same has been true since the crash of 2009: The Vanguard REIT ETF rose 253% between March 2009 and May 2013, far exceeding a 140% gain for the S&P 500.
After a poor showing last year, REITs may be poised for a rebound in 2014. Income investors who jump on this opportunity may be able to generate a healthy income stream with the upside of capital appreciation.
This article is brought to you courtesy of Ian Wyatt from Wyatt Investment Research.