REITs And Rising Rates: It's Not Always Bad News

With many investors expecting the Federal Reserve to boost interest rates multiple times this year, a forecast that includes expectations for rate hike this month, there has been plenty of chatter regarding rate-sensitive equity sectors.

That conversation often includes consumer staples names and almost certainly includes utilities, the sector most inversely correlated to rising Treasury yields. It also includes the real estate sector and real estate investment trusts (REITs).

For all the talk about rising interest rates, the iShares U.S. Real Estate ETF IYR, one of the largest REIT ETFs, is higher by 3 percent year-to-date. Perhaps that's a sign that rising rates don't harm REITs as much as previously thought. Historical data indicate as much.

“During the 1994-1995 tightening cycle, when rate hikes were significant and frequent within a short period, the Dow Jones U.S. Select REIT Index posted negative returns (-5.81%). However, the index had positive cumulative returns (2.64% and 63.66%) during the other two tightening cycles, during which rate increases were fairly steady over time,” said S&P Dow Jones Indices in a recent note.

The $4.38 billion IYR tracks the Dow Jones U.S. Real Estate Index, which is comparable to the aforementioned real estate benchmark.

While it's good news that IYR and other REIT ETFs have been steady this year amid rate hike speculation, investors should note the point of diversified REIT ETFs is offer exposure to multiple corners of the REIT market. The trade-off there is that some REIT sub-sectors are more rate-sensitive than others due to varying lease terms.

“It is important to remember that REITs can differ meaningfully in terms of average lease durations based on the underlying properties they own.  For example, Hotel REITs may invest in hotels and motels that have daily lease terms, but the lease life for Healthcare REITs can be 10 years, because these REITs invest in healthcare-related properties such as hospitals and senior housing,” said S&P Dow Jones Indices.

The index provider notes hotel REITs aren't usually sensitive to changes in interest rates due to relatively short lease terms. Healthcare REITs are 9.5 percent of IYR's roster while hotel and resort REITs account for 4.3 percent of the ETF's weight. IYR's largest REIT exposure is 28.1 percent to specialized REITs.