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Recently, public REITs have had a turbulent run. And while the broader markets had taken a tumble as well, REITs seem to have been hit the hardest.1 But why?
Mainly, investors are concerned with the uncertainty caused by rising interest rates, increased inflation, and stock market volatility. Uncertainty is high, the market has become pessimistic, and the reaction is often to sell. But it shouldn’t be. Remember, REITs are historically a defensive investment tool, and often only experience excessive volatility due to investor overreaction.2
Does increased stock market volatility mean much for REITs?
In early 2018, the stock market experienced its sharpest single-day point drop in the Dow’s 121-year history, falling 1,175 points by the closing bell. Analysts cited concerns regarding rising interest rates and the pace of the Federal Reserve’s short-term rate hikes as the main triggers.3
And while the plunge affected real estate investments, with the FTSE NAREIT All Equity REIT Index experiencing a 2.9 percent drop, it’s expected to be short-lived.3 REITs, compared to the rest of the stock market, march to the beat of their own drum. While the stock market is driven by the business cycle and the rise and fall of economic production, REITs, while correlated to the market, mainly follow the real estate cycle.
Growing economy + rising interest rates = good news for REIT investors
Not surprisingly, real estate investments can experience an initial sell-off as investors become concerned about how real estate will fare in a changing environment. However, real estate tends to rebound and grow if rising market rates are responding to economic growth, which is what appears to be happening now. The unemployment rate is down almost 6 percent since 2010, and as a result, wages are trending higher.4 The January jobs report saw a 2.98 percent increase in wages year-over-year, the highest percentage growth in wages since the summer of 2009.5 As the economy expands, the demand for commercial real estate may also grow as vacancy rates lower and rental incomes increase.
Shopping the sale rack
Recently, REITs have been overlooked and undervalued. In 2017, investors perceive to have experienced dramatic underperformance compared to the broader markets. However, when you take a closer look, the data tells a slightly different story. In 2017, the REIT industry generated total returns of 9.27 percent, in line historically with long-term average of 9.72 percent.6 The perception of underperformance arises when you compare the average performance of REITs to the abnormal returns in other segments of the stock market.
According to the long-term Fama-French data, as an investor, you should understand that last year’s market outperformance was extremely rare. Since mid-1926, this type of outperformance has occurred six percent of the time—including during the 1929 market bubble that ended with “Black Tuesday”, along with the dot-com bubble of the late 1990s.6
The recent sell-off due to increased market volatility has also left some REITs in the bargain bin. As of late February, public REITs were selling at roughly a 12 to 15 percent discount to the net asset value of their properties.1 This divide between REIT stock prices and the actual value of assets means there’s an opportunity for investors to pick up REIT stocks at discounted prices.
Looking to the future
The Federal Reserve has signaled that it will continue to raise interest rates through 2019.7 But as an investor, consider that this rising interest rate environment is a potential positive for most aspects of real estate, especially properties that utilize short-term leases that can capture the income generated by a property to keep pace with a growing economic footprint. And during times of market volatility, REITs have the ability to act as an inexpensive defensive investment vehicle and provide stable and predictable income, along with the potential to hedge against inflation and rising interest rates.