Real estate investment trusts have served as the epicenter for a rather heated debate in the second half this year.
On the one hand, REITs have outperformed the S&P 500 for the better part of the year.
It is worth noting, however, that REIT share prices have skyrocketed, leading many to think that these dividend-yielding vehicles are overextended. What's more, many investors think that the bottom is about to drop out, thanks to a looming interest rate increase.
There are experts on both sides of this debate, which raises the question of what the future holds for REITs.
Speculation has more or less run rampant, but REITs will likely land somewhere in the middle of the speculation spectrum.
Although a rate increase could eat into REITs' bottom lines via increased borrowing costs, the chances of the bottom falling out of such a hot industry isn't likely. In other words, the scale may not tip in favor of either sentiment anytime soon.
But with the right strategy, investors should be able to weather the storm, no matter which direction the winds blow.
In fact, it is entirely possible to diversify REIT portfolios in a way that mitigates the risk of a rate increase. Perhaps even more importantly, the right allocation of capital could actually turn higher rates into an opportunity.
More on why that is later, but let's first look at why fears about a rate increase appear overblown. Although concerns are justified, they are by no means worth losing sleep over for those who have properly diversified portfolios.
The performance of REITs at least over the long term are more closely correlated to the economic health of the country than incremental rate increases. Fortunately, the U.S. economy has made great strides since the last recession, and the country is better off than it has been in a long time.
The best hedges against a rate increase are REITs that offer relatively short lease windows. The shorter the lease, the faster a company can compensate for a looming increase in borrowing costs.
Buttressed by a growing economy, it is entirely possible for REITs that offer shorter lease terms to actually use a rate increase to their advantage.
As Drew Babin, senior research analyst at Robert W. Baird, said, positive economic indicators can actually benefit REITs that are prone to offering shorter lease windows.
"If interest rates are rising for the right reason, that there's growth in the underlying economy, you want to be in sectors that have shorter lease terms. You want to own hotels, self storage, apartment sectors, [places] where the landlords can take advantage of the rate hike," Babin says.
Few sectors in the REIT industry are more insulated from rate increases than hotels if for no other reason that these offer by-the-night leases to those using their facilities. In other words, hotels are awarded the opportunity to adjust their strategy with every new occupant.
When rates go up, hotels will be one of the few sectors to be able to immediately compensate for the jump in borrowing costs. As it turns out, consistent turnover actually works in their favor.
That said, there is more than a good chance that the hotel sector won't only weather the rate increase storm but actually come out on the other end stronger.
By the time a rate increase is implemented, hotels will have had more than enough time to adjust their strategies to compensate for higher borrowing costs. One hotel REIT, in particular, is poised to fare better than its rivals: Apple Hospitality.
The REIT has one of the largest portfolios of upscale, select service hotels in the U.S., with 236 hotels and 30,000 guest rooms, with the Hilton Hotels and Marriott International brands making up all its holdings. Following a recent merger with Apple REIT Ten, Apple Hospitality has an enterprise value of about $5.7 billion.
Moreover, these two brands are diverse enough to cover every aspect of the hotel industry, from extended-stay locations to full-service accommodations. Few hotel REITs, for that matter, have a brand affiliation that can rival that of Apple Hospitality, which is why its chances of surviving a rate increase are high.
In the face of a strengthening economy, more travelers will turn to brands they trust, such as Hilton Hotels and Marriott International.
If recent performance is any indication, Apple Hospitality should be sitting pretty.
"In Q2-16 APLE generated solid RevPAR growth, increasing adjusted EBITDA to $100.5 million and $179.1 million, an increase of almost 12% for the quarter and over 11% year-to-date from last year," according toSeeking Alpha. "APLE's Modified FFO per share grew to $0.52 for the second quarter and $0.91 year-to-date, representing growth of 18% for the second quarter and 17% year-to-date."
Of particular importance, however, is Apple Hospitality's propensity to mitigate risk through diversification. Outside operating in 33 states, the company prides itself on offering a wide variety of options for its customers.
Not unlike most hotel REITs in the sector, Apple Hospitality also stands to benefit from a strengthening economy.
As recently as September, employers were said to have added 156,000 new positions to the national workforce, according to the Department of Labor Statistics.
That same workforce is expected to account for improvements in hotel vacancies, as more people should be traveling for business than in recent history.
Not only should Apple Hospitality be able to benefit from increased travelers, but its short-term lease nature should allow it to compensate for a rate increase. As a result, Apple Hospitality should remain relatively insulated to borrowing cost fluctuations that may affect other REITs.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.