Here's a Long-Term Way to Shield REIT Portfolios From a Rate Hike

In a statement that surprised few people, Federal Reserve officials said recently that the case for increasing interest rates has strengthened because of the economy's steady if unspectacular growth rate and low unemployment rate. 

Any increase in borrowing costs that results from such a move could eat into the bottom line of the real estate investment trust sector that has largely performed well this year. The result: Many investors are ready to temper their expectations for this sector that has been outpacing the S&P 500.

However, they may want to reconsider such a pessimistic view. 

A rate increase isn't likely to threaten the long-term performance of REITs. Rather, at worst, it could create a minor obstacle that can be easily navigated with the right investment strategy.

The economy's strength should be enough to offset any incremental rate increase that the industry experiences. Given the health of the economy, the outlook for REITs remains attractive. 

"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," said Drew Babin, senior research analyst for Robert W. Baird in Philadelphia.

"But if we have a rate hike and [the 10-year Treasury] goes back down to 1.5%, you'll want to own REITs with longer leases like health care sectors, where they have that stability," he said.

To be sure, a rate increase could affect REITs in the near term, particularly if it is a modest increase as expected. But REITs should be viewed as a long-term play.

One particularly interesting long-term play is Realty Income (O) .

Realty Income has said that it is "dedicated to providing shareholders with dependable monthly income."

Shares of Realty Income fell more than 2% in Wednesday trading.

On Oct. 11, Realty Income announced a $0.202 dividend return per share or an annualized amount of $2.424 per share no later than Nov. 15. The dividend has increased for 76 consecutive quarters. 

The San Diego-based REIT has declared 556 consecutive common stock monthly dividends.

Such stability is due largely to its relatively predictable income stream. The secret: Long-term, triple-net leases in industries more or less insulated from competitors.

Realty Income has traded on the New York Stock Exchange since 1994 and invests in free-standing assets in prime locations with lots of exposure. In all, Realty Income owns more than 4,600 properties, spanning 47 industries and 49 states, including Puerto Rico, so it is nicely diversified in this regard.

The company invests for the long term in triple-net lease properties.

Triple-net lease deals require tenants to pay a property's operating expenses, including insurance, maintenance and taxes. The downside is that the rate of growth can be slower than for other types of real estate deals. 

But the upside is low risk. Realty Income is more insulated from rising property expenses than those REITs that don't operate under a triple-net lease umbrella.

What's more, that same insulation is expected to help maintain the company's consistency that investors have come to expect in the event borrowing costs increase.

The REIT's occupancy rate has been strong. Halfway through the year, the REIT boasted a 98.9% occupancy rate, and there is no reason to suspect that those numbers will drop anytime soon.

By the end of the first half, adjusted funds from operations "per share increased 4.4% to $0.71" compared with a year earlier, according to Realty Income's, operating results.

In response to its success in the first half, John P. Case, Realty Income's chief executive, said that it was raising its "2016 acquisitions guidance to approximately $1.25 billion from our prior estimate of $900 million."

All things considered, Realty Income has generated consistent returns for two decades. Investors seeking a safe, long-term real estate investment should place Realty Income high on their list.

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

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