VNQ Vanguard Real Estate ETF

The going wasn’t easy for the REIT industry in 2013, particularly in the latter part of the year which saw some volatile business. The sector had held up pretty well till mid May. Then came taper talks and with it, rising interest rates. This by and large impacted the performance of the REIT sector.
 
Finally the Taper
 
After months of speculation, the Fed finally announced that it was beginning to taper its QE bond buying program in its last FOMC meeting. On a monthly basis, the Fed will now buy $75 billion in monthly assets, down from the current rate of $85 billion a month.
 
A gradually improving economy and lower levels of unemployment were cited as the chief reasons by the Fed to start tapering (read: Fed Tapers Bond Purchases: 3 ETFs in Focus on the News).
 
However, the best part of the taper news is that the Fed would continue to keep interest rates low throughout 2014 in order to boost economic growth. In other words, the Fed made it very clear that ‘Taper’ and ‘Rising Rates’ are not synonymous. The Fed will be following an accommodative monetary policy stance until the unemployment rate drops below 6.5%.
 
Impact of Fed Outcome on Interest Rates & REITs
 
The news of tapering has seen a mixed reaction from market experts. A section of analysts believe that 2014 will definitely be positive for REITs as the Fed will continue to keep interest rates low through the year. 
 
However, some experts believe that tapering by the Fed will cause interest rates to rise. In fact, the rates for the 10-year U.S. Treasury have jumped to 2.94% as of Dec 23, 2013 from 2.89% as on Dec 18 (read: Rising Rates and Soaring Stocks: Time for Convertible Bond ETFs).
 
This represents a modest jump, as current yields are almost at a two-month high. The rise in yields implies that investors are not convinced that the Fed will succeed in keeping interest rates at rock bottom for long.  Though the Fed might keep short-term rates near zero, an improving economy would definitely lead to a rise in 10-year Treasury yields.
 
A rising interest rate environment raises concerns about the performance of REIT stocks. A jump in rates would force REITs to pay higher amounts to borrow money which in turn would impact its dividend yield. This is due to the fact that REITs are required to distribute at least 90% of their annual taxable income in the form of dividends to shareholders.
 
The spike in 10-year Treasury yields caused some of the popular REIT ETFs including the Vanguard REIT ETF (VNQ), iShares Dow Jones US Real Estate Index Fund (IYR), SPDR Dow Jones REIT ETF and iShares Cohen & Steers Realty Majors Index Fund (ICF) to fall 0.6% to 1.8%, during the four days following the taper announcement.
 
Road Ahead & Bottom Line
 
As per popular belief, REITs will be affected by a surge in interest rates. However, according to some experts, this negative relation does not hold over the long term.
 
A rise in interest rates usually signals an improving economy, which is good for REITs. An improving economy drives demand for properties offered by REITs, thereby boosting the returns for the space (read: A Comprehensive Guide to REIT ETFs).
 
Moreover, a study by Brad Case, VP of Research with the National Association of Real Estate Investment Trusts (NAREIT) reveals an interesting truth. It highlights the fact that since 1995, REITs have delivered decent returns in 12 out of 16 periods of rising rates.
 
The study also admits that though REITs will produce decent returns during times of rising rates, it will tend to underperform the broad equity markets. The contrary holds true in times of falling rates. During the period from March 2011 to April 2013, when rates fell from 3.5% to 1.5%, REITs outperformed stocks, gaining 27% compared to a 20% gain for the S&P 500.
 
This leads us to an important conclusion. REITs are expected to perform well during falling rates and even when rates are rising moderately. However, they will underperform stocks if interest rates rise sharply (also see all the real estate ETFs here).
 
Hence long-term investors should not be bothered too much about rising rates, and use REITs to diversify their portfolio and as a hedge against inflation, especially if rates slowly rise over the coming months and years.
 
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ISHARS-C&S REIT (ICF): ETF Research Reports
 
ISHARS-US REAL (IYR): ETF Research Reports
 
VIPERS-REIT (VNQ): ETF Research Reports
 
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