REITs and Rates

August 29th, 2013
in contributors, syndication

Investing Daily Article of the Week

by Ben Shepherd, Investing Daily

It’s little surprise that Fed Chairman Ben Bernanke’s comments on the impending end of quantitative easing have cause an uptick in market volatility. While the tapering process will begin slowing the flow of easy money into the financial system, it also signals that interest rates are also likely to start rising sooner rather than later.

As a result, interest sensitive investments like bonds have experienced steadily rising yields since May, as investors have sold out. The iShares Barclays Aggregate Bond Fund (NYSE: AGG), which measures the performance of the total United States investment grade bond market, has declined by 5.5 percent just since April 30.

Follow up:

The prospects of better yielding new issues are luring money out of existing bonds. Investors not only want to avoid the pain of falling prices on old bonds, they also want to get a piece of the better yields they believe are likely.

Real estate investment trusts (REITs) have also seen a sharp increase in volatility over the past few months. The Dow Jones Equity All REIT Total Return Index had been steadily rising, beginning the year at 1116 before peaking at 1329 in late May. Since then, the index has plunged to its current level of 1119, basically back to where it was at the start of the year.

Thanks to their tax-advantaged structure, REITs are required to distribute a minimum of 90 percent of their income to investors. As a result, many investors treat them as bond-like investments so, when interest rates go up and inflation is on the ascendency, Treasury bonds and other more conventional fixed income securities become more attractive. But that thinking actually overlooks two key features which make REITs more attractive when rates and inflation are rising.

The first is that REITs have the ability to increase rents along with rates and inflation. In the case of residential REITs, leases are typically renegotiated on an annual basis given the REITs’ ample leeway to grow cash flows in tandem with the economic environment. And while many commercial or industrial leases are negotiated on five- or even ten-year terms, many include provisions for stepping up rental rates based on some sort of a benchmark such as the London Interbank Offered Rate or the 10-year Treasury.

So, unlike a bond, REITs have the ability to change their income streams to account for higher rates.

And just as bonds have a principal value, REITs have what amounts to a net asset value or the price their real estate properties would fetch in the open market.

When inflation and interest rates are ticking up, hard assets come into higher demand. As a result, real estate has long been a traditional inflation hedge, since property values tend to appreciate in that type of environment.

But if you actually purchase a piece of property, you’re locking up a substantial sum of money for an extended period of time and reducing your ability to diversify your investments.

REITs, on the other hand, allow you to diversify your real estate investments across a wide variety of both geographies and types of properties at a relatively low cost. And over the long haul, while REIT share prices are more volatile than the values of actual real estate, their return profiles are virtually identical.

The upshot: REITs make much more sense for most investors than a direct investment in property.

One REIT that I find particularly attractive is HCP (NYSE: HCP).

HCP focuses on health care related properties across the US. Its holdings breakdown accordingly: senior-housing developments (35 percent of assets); nursing homes (29 percent); life-sciences facilities (17 percent); medical offices (15 percent), and hospitals (3 percent).

The REIT’s health care focus makes it what I would consider a triple play on current trends in the US.

First, to minimize costs and ensure a stable tenant base, HCP offers mostly long-term, “triple-net” leases, which means tenants pay for maintenance and taxes for at least 10 years. Thanks to these lock-ins, less than half of HCP’s leases expire in the next seven years.

In addition, the triple-net leases are inflation-protected, stipulating that rents will rise annually by the rate of inflation, which is now running at 2.5 percent in the real estate industry.

Secondly, with 35 percent of HCP’s assets in senior-living communities, HCP has demographics on its side. About 13 percent of the US population is currently over 65. But this percentage is expected to rise dramatically. Each day for the next two decades, some 10,000 Americans will be celebrating their 65th birthday. By 2050, a quarter of the US population is expected to be over 65, up from 15 percent in 2020.

Finally, largely due to America’s aging population, health care spending in the country is expected to rise about 6 percent annually over the next two decades. This should also be good news for medical practices, life-sciences companies and hospitals, helping to ensure strong demand for HCP’s properties.

HCP offers all of the interest rate and inflation protection of a more conventional REIT, while also leveraging the upside potential of shifting American demographics.


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