How the Upcoming Fed Decision Could Affect REITs

Real Estate Investment Trusts have recently been one of the market's brightest sectors. Shortly before the Federal Reserve Open Market Committee's mid-June meeting to consider interest rate policy, the MSCI REIT Index had returned 8% for all of 2016 and a sparkling 16.49% during the previous 12 months, when the S&P 500 Index generated a comparatively meager 1.72%.

But what will happen to REITs after the Fed meets to decide future rates? REIT valuations are sensitive to rate trends. The funds invest in real estate projects financed with loans, the cost of which depends on interest rates. They also generate much of their return in the form of dividends, which tend to command lower valuations in rising rate environments.

But experts say REITs' future doesn't hinge on the outcome of a single Fed meeting. "A lot of people are focused on what the Fed may or may not do," says J. Scott Craig, who manages the Eaton Vance Real Estate Fund for Eaton Vance Management in Boston. "But real estate is a long-duration asset class. It's much more important what happens on the long end of the curve than on the short end of the curve. Like orders of magnitude more important."

Craig notes that the current forward curve for U.S. Treasuries, which is based on investor expectations for inflation and consumer behavior as well as Fed actions, implies that in 2021 the interest rate on 10-Year Treasuries will be about 2.25%. With 10-Year Treasury rates now just over just over 1.6%, this would be a modest increase in long-term rates, he says. "If that is what comes to pass, that's a very supportive backdrop for real estate valuations and for REIT valuations," Craig says.

Maintaining a long-term focus is also advised by Benjamin Sullivan, a certified financial planner at Palisades Hudson Financial Group in Austin, Texas. "One of the biggest mistakes investors make is trying to trade based on a very accurate prediction for which the market has already accounted," Sullivan adds. "While rising interest rates are predicted to be a drag on REIT returns, the REIT market is already very aware of this likely increase."

He says that REIT valuations will, however, likely react to the Fed's action or inaction, falling in the absence of a rate hike and climbing if the Fed opts do to nothing. But he adds that the reaction could be brief and may reverse itself.

If the Fed raises rates, that will be interpreted as an endorsement of the economy's strength, Sullivan says. "In a growing economy, improvements in real estate fundamentals, such as occupancy levels and rent growth, should help increase earnings in the industry and offset the drag of rate hikes," he says.

How about no Fed action? "If the Fed surprises markets and doesn't raise rates in the coming months, REIT prices could move higher," Sullivan says. "Last August, REIT indexes sharply declined as the market anticipated a rate hike, but REITs quickly rebounded when rates remained unchanged."

Sullivan suggests that investors who own REITs consider rebalancing to account for the asset class's market outperformance. "When REIT prices rise more than other parts of a portfolio, as they have done recently, this is a signal to reduce your stake to its original target percentage," he says.

Sullivan recommends most investors allocate about 7.5% of stock portfolios to REITs. The funds offer inflation protection and dividend returns but are particularly valued for their diversification attributes. As an alternative asset class, they tend to move independently of stocks and bonds, giving investors a hedge against broad declines in traditional asset classes.

Craig cautions against major moves into or out of REITs to try to profit from reaction to the Fed meeting. "It's not an approach that I use in my own fund, and it's frankly not an approach that I recommend," he says. "So many people have been so wrong already on what the Fed will or won't do. For example, three or four months ago people were expecting bigger and faster increases this year than we now think is likely. For those who were confident in that view and placed big bets, they've just lost out."

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