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What NAREIT Is Missing About Rising Rates

  • NAREIT believes REIT stocks will do just fine in a rising rate environment.
  • The logic being that the businesses will thrive, because the economy will be doing well when the Fed raises rates.
  • But that misses a key fact about the market today: investor sentiment.

In the May/June issue of REIT, published by the National Association of Real Estate Investment Trusts, NAREIT highlights the history of REIT prices during rising rate environments. It's generally favorable, but not uniformly so. And that's why this time won't be different, even though REIT stocks are likely to take a hit.

The history
The story in REIT highlights 16 periods of rising rates dating back to 1996. REIT stocks declined in just four of the historical examples. That's good news. These results were largely driven by sound fundamentals. Looking at today, Steve Shigekawa, head of Neuberger Berman's global real estate securities practice, explained to the magazine, "As long as we see higher interest rates driven by economic growth and job growth, that should be supportive of demand for commercial real estate."

NAREIT's Calvin Schnure added that context matters, comparing today's environment to 2004 to 2006: "What happened to REITs is quite informative: Solid economic growth boosted occupancy and rents, helping the REIT sector deliver a 69 percent total return over this period-well ahead of the S&P 500." Essentially, these two industry watchers are talking about rising rates being driven by a strengthening economy, and this leading to strong business results at REITs.

The fly in the economic ointment
I won't argue with the logic of this. It makes perfect sense. But there are some problems here. First, the U.S. economy isn't exactly robust right now. In fact, this recovery has been something of an off-again/on-again drag that's left the country alternating between fears of another recession and surprise at how strong the economy has been growing - often, all within the same year.

For example, in 2014, the GDP growth rate fell well into negative territory in the first quarter (a contraction of 2%), was above 4% in each of the next two quarters, and then started to trend lower in the fourth, dipping toward 2%. It fell into negative territory again in the first quarter of 2015. That's hardly the stuff of robust economic uptrends.

That can change, of course, and I hope it does. But I don't believe the underpinnings of economic strength will be particularly strong when interest rates start to rise. Granted, the Federal Reserve is talking about a slow increase, not a dramatic climb. However, that's just a testament to how weak the current economy really may be.

The big problem
However, this is not my biggest concern. The big problem I see is that interest rates aren't just low, they are at historic lows. They have been pushed down and kept down by the Federal Reserve in a desperate attempt to boost the U.S. economy after the deep 2007-2009 recession. The recession ended around six years ago, and the Federal Reserve is still keeping us at near-zero interest rates. In fact, it's gone even further, launching us into quantitative easing. These efforts have had a big impact, but not on the economy - the real impact has been on investor psychology.

With cash and other safe short-term investments earning virtually nothing, investors have had to find a more productive place to put their cash. That, in turn, has fueled demand for high-yield investments. That's where real estate investment trusts come in. Although backed by hard assets, REITs have seen their yields compress to extremely low levels.

For example, National Retail Properties' (NYSE:NNN) yield hovered in the 6% range between 2006 and 2008. As the 2007-2009 property-led recession peaked, investors got spooked and NNN's yield spiked to over 10%. But interest rate cuts have driven investor demand, and the yield is now around 4.5%. The yield was as low as 3.75% earlier this year when REIT prices peaked.

While I can't tell you what the "right" yield for NNN is, I know that the current yield is below where I'd feel comfortable buying shares of the REIT. That has nothing to do with it as a company. In fact, I like NNN as a company. You don't grow your dividend every year for 25 years without doing something right. And the consistent history of giving back to shareholders speaks volumes about the company's management.

Is National Retail Properties a good company? Yes. Is NNN cheap? No. In the end, the company's business strength says nothing about investor sentiment, which is what drives stocks over short periods of time. And while rising rate environments have often led to REIT shares moving higher (12 out of 16 times since 1996, as NAREIT reminds us), the four times when REIT shares faltered show that they don't always move higher in such environments.

And since the current rate level is historically low and REIT valuations are already at high levels, it's hard for me to believe that rising rates will lead investors to boost REIT shares to even higher levels. It's particularly hard for me to believe that the prices could move as much as 70% higher, the comparison that NAREIT's Schnure highlighted from 2004 to 2006. Note that NNN's shares are already up around 125% since the start of 2009.

At some point, REIT prices and valuations will come back down. That's how the market works, swinging from extreme to extreme in pendulum-like fashion. Could they go higher? Sure. I'm just not willing to bet on a greater fool to buy me out of an expensive purchase.

This time isn't different
So this time isn't different, and doesn't fly in the face of history in any way. Rising rates don't always lead REIT shares to rise in value. Currently high REIT valuations suggest that the risk of investors getting spooked by a rising rate environment is very real; just look at what's happened since REIT shares peaked earlier this year for evidence of that. And neither of these facts has anything to do with REIT fundamentals, but instead, are about investor sentiment, which is the real risk that REITs and other high-yielding securities face right now.

In other words, if the Fed starts to raise rates, I fully expect investor reaction to lead to lower prices for any assets that were driven up by yield-seeking speculation. That includes REITs.


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