The REIT market is down lately, in case you haven't heard. Specifically, the MSCI US REIT Index, the bellwether of the real estate investment trust industry, is down 6% this month and almost 10% from its all-time high in early August. Yes, it seems after five straight years of outperforming the S&P 500, the Dow and Nasdaq, REITs are taking a breather. What's happening? A number of things are probably contributing to the sector's recent weakness: Rising interest rates. Fears of a real estate bubble. Higher oil prices. Volatility in the REIT market has increased with the arrival of more and more institutional market-timers and momentum players. Rising markets attract that kind of money, which tends to disappear in falling markets. It's fair to surmise that there's been some profit-taking as well. But take heart, these fears are probably overblown, particularly for buy-and-hold investors -- i.e., those more focused on dividends than short-term price movements. Let's address these concerns one by one.
Rising interest rates: It's true that, in the short term, REIT prices are sensitive to changes in interest rate movements, moving in opposite directions. With rates creeping up (and many analysts suggesting more to follow), yield-oriented instruments react negatively. However, it's also true that REIT prices are weakly correlated to interest rates over the longer term -- they move more consistently with the prices of real estate. Which leads to... Fears of falling real estate markets: There has been much talk about a real estate "bubble" -- even Alan Greenspan has made reference to it. Perhaps there's something to this; the condominium gold rush comes to mind. But commercial real estate (such as office buildings and shopping malls) is a different matter. The largest decline in the NCREIF Index, which tracks property values (as opposed to REIT stock prices), was 9.6% between 1990 and 1992. So, avoid apartment REITs with large exposure to the condo market, either through property sales to converters, or worse, ones that do it themselves. Otherwise, take a deep breath, and don't sour on the entire sector. Rising fuel prices: Until someone develops an effective and cheap alternative energy source, the global economy is extremely sensitive to oil prices. Some industries, like air travel, are more sensitive than others. Real estate is no exception. Higher fuel oil prices mean it's more expensive to heat buildings. Higher gasoline prices mean it's more expensive to drive to the mall. But here's the twist: Many commercial leases contain escalation clauses that require tenants to pay additional rent when expenses increase, so landlords can, in effect, pass rising energy costs on to their tenants. Apartment leases don't have these clauses, but the lease terms are shorter than the typical commercial lease, so they can adjust their rents much more quickly. Sure, real estate prices can decline, and REIT share prices along with them, but it's interesting to look at the divergence of price and performance that's taken place since 2000. Real estate prices -- both commercial and residential -- have soared, partly driven by falling interest rates. A flood of new capital, much of it from overseas, has come into real estate (both directly into property acquisitions and through REITs), in reaction to the lack of better investment alternatives, as well as the perceived safety of real estate compared with technology and telecom. Meanwhile, after the tech bubble burst, the U.S. economy slid into recession, with many businesses retrenching or failing. That pushed rents down and vacancies up. Even as the underlying performance of commercial real estate -- as measured by cash flow -- went down, prices kept going up.
Things have picked up since then. The economy is much healthier now. Businesses are growing again, using more office space. Industrial production has rebounded, which is good news for owners of warehouse and distribution facilities. Consumers continue to spend money at shopping centers and malls. For owners of multifamily properties, the silver lining of rising interest rates is the deceleration of tenants leaving to buy homes with cheap mortgages. More demand for space translates to rising rents and decreasing vacancies, and that means that cash flows are on the rise. So, even if prices do start to drop, investors have the comfort of the enhanced safety and future growth of REIT dividends. Don't forget the other
characteristics of REITs, which make them useful components of an investment portfolio: Low Beta: Over time, relative to the broader markets, REITs underperform in bull markets and overperform in bear markets. While this relationship doesn't always hold in the short term, keep in mind that REITs are not tech stocks -- think medium- to long-term hold. Strong Operating Leverage: In real estate, a significant portion of expenses are fixed, such as real estate taxes and maintenance costs. This means most of every incremental dollar of revenue, as occupancies and rents increase, drops to the bottom line. Low Financial Leverage: With an average debt-to-total enterprise value of 40%, REIT cash flows and property values would have to experience an unprecedented crash of epic proportions before the equity would be wiped out. That would be kind of like a major earthquake combined with a major hurricane and, as someone once said: "If that happens, we've got bigger problems." Plus, most of this debt, 92%, is fixed rate, insulating companies from rising interest rates. So before you press the panic button on REITs, remember one of the reasons you invested in them in the first place -- safety and stability -- which are still very much intact.