The following post was written by Ben Carlson at A Wealth of Common Sense.
As interest rates have spiked higher since early May, many income producing investments have been hit hard. Higher interest rates act as competition for yield hungry investors. This is one of the main reasons why high yielding investments have sold off since the rise in rates began a few months ago.
The 10 year treasury yield has increased by almost 1.3% since the lows of May. In that time, high yielding investments such as high-yield dividend stocks, preferred stocks, junk bonds and REITs (Real Estate Investment Trusts) have all experienced a large sell-off.
REITs are an interesting asset class, in part because of their high yield, but also because the aggregate real estate market is so large. According to Rick Ferri, the commercial real estate market is nearly the same size as the stock market. REITs give you the opportunity to invest in a diversified mix of residential, retail, office and industrial real estate. Because of the way they are structured for tax purposes, REITs pay out the majority of their earnings to investors in the form of dividends.
The iShares S&P/TSX REIT ETF (ticker XRE) is down from almost 18% since May while the yield is up about 19% from a low of 4.3% to the current 5.2%. The two largest holdings for XRE, RioCan and H&R REIT, make up nearly 35% of the entire ETF.
RioCan Real Estate (ticker REI.UN) has seen its share price drop almost -18% since May as the dividend yield has jumped to nearly 5% from a low of about 4%. That means the dividend yield is up almost 23% in that time. H&R REIT (ticker HR.UN) has lost almost 17% while the dividend yield has risen over 37% from 4.3% to 5.9%. So the rise in dividend rates for REITs has been similar to the rise in bond interest rates.
The dividend yields for these two REITs look very appetizing, but they can continue to go higher based on the historical averages. According to Capital IQ, the 5 year average yield for RioCan is 6.6%. For H&R the 5 year average yield is 6.3%. Both stocks are fast approaching those averages, but to get back there would mean more pain in share price in the meantime.
Looking for value in beaten down markets requires a balancing act of sorts. You don’t want to get caught catching a falling knife, but at some point things are bound to turn around as prices continue to decrease and yields rise.
However, at a certain point, value will win out. Your tolerance for risk until that value gets recognized should determine whether or not you can stomach further losses in REITs. Averaging into these names in case of further share price weakness could be a way to reduce risk. And you can get paid to wait through the higher yields as well.
Don’t Try to Forecast Rates
There’s no way to guess the direction of interest rates, so it’s difficult to make a decision on REITs based solely on where you think rates will be in the future. There are simply far too many variables to consider, such as economic growth, inflation, loan demand, investor appetite for risk and the decisions of the various central banks around the world.
REITs are also heavily tied to economic growth since appetite for rents can be cyclical and correlated to the state of the economy. And one of the reasons that interest rates rise is because economic growth is improving. That means higher rates can also act as a positive for REITs as things improve.
What do you think? Is it time to load up on REITs or will there be more pain to come?