Here’s How Equity REITs Will Respond to a Rate Hike -- and How to Invest - TheStreet

NEW YORK (TheStreet) -- With market observers expecting the Federal Reserve to raise interest rates this year, some investors may be worried about what will happen to their holdings of real estate investment trusts.

They should know that even though equity REITs won't perform as well when rates are rising, they'll still be better investments than a lot of alternatives.

History shows that equity REITs perform worse in rising rate environments than they do during periods of falling interest rates, said Robert Johnson, president and CEO of The American College of Financial Services and lead author of a recent McGraw-Hill book, Invest With the Fed.

"Specifically for equity REITs, during expansive monetary policy periods from 1972 to 2013, when the Fed is lowering interest rates, equity REITs returned 16.77% annually," Johnson said. "On the other hand, during restrictive periods between 1972 and 2013 -- that is, periods of increasing rates -- equity REITs returned 9.77% annually."

It can take some time for rising interest rates to affect actual REIT operations and financing, said Charlie Boscarino, president of Retail Solutions Advisors, an organization that's engaged in commercial real estate management.

"Most REITs have already been able to refinance their debts on a long-term basis," Boscarino said. "Consequently, concerns relating to financing costs due to a rate hike will only come several years down the road"

Boscarino points to Hersha Hospitality Trust (HT) - Get Report, which recently said in its second-quarter 2015 earnings results that it refinanced its Hyatt Union Square mortgage within a favorable financing environment, which should help it save about $1 million annually. On this particular property, with a maturing date of June 2019, Hersha doesn't need to worry about an interest rate hike in the next few years.

Nevertheless, the price of REIT shares is another thing, and Johnson said that investors don't need to wait long to see the impact on them.

"From our research, we've found that it's the direction/trend of interest rates, and not the absolute level of interest rate that makes the difference," said Johnson.

In essence, once the Fed begins a rate-hike cycle, investors should expect that equity REITs won't perform as well as they do in low-rate environments.

Still, investors shouldn't dump their equity REITs, because they remain one of the best assets to consider in restrictive cycles.

"The return from equity REITs was one of the five best of all asset classes during restrictive periods," says Johnson. "The only asset classes that had a higher return during restrictive periods were commodities [as measured by the Goldman Sachs/S&P GSCI Commodity Index] 17.66%, Scandinavian country equities 17.14%, emerging markets 16.53% and energy 9.77%."

It is worth noting that equity REITs outperformed the S&P 500 during tightening cycles as well. In tightening cycles between 1972 and 2013, the S&P 500 returned an average of 5.89% annually, a 3.88 percentage point decrease from the 9.77% average return of equity REITs during the same period.

There's another thing to note, though.

"Equity REITs investors have to be long-term minded in other to see their portfolio perform well during the upcoming tightening cycle," said Boscarino. "While equity REITs perform well during restrictive cycles overall, it's not always the case that they'd be good investments when rate are rising. In any given short-term period, the positive relationship may not be true."

What's more, investors still have to do their due diligence when selecting which equities to hold.

"Investors have to take time to check what the underlying real estate of any REIT is," Johnson said. "Investors should know that if a REIT's underlying real estate is concentrated in a particular geographic area, such REIT will perform in accordance to the state of economy of the area."

In short, to perform well in a rising-rate environment, it would be beneficial to go with well-diversified REITs, as opposed to REITs that are invested in mainly one sector or geographic area.

To that end, some well-diversified equity REITs include W.P Carey (WPC) - Get Report, which has property types including office (32%), industrial (26%), warehouse/distribution (18%), retail (12%) self-storage (5%) and other (8%). You might also want to note that this REIT is down by more than 10% this year.

The Vanguard REIT Index Fund (VNQ) - Get Report also provides a broad, diversified real estate exposure. It's well-diversified, with its top 10 holdings amounting to only 36.3% of its total holdings.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.