Best REITs for Rising Interest Rates

real estate investmentReal Estate Investment Trusts (REITs), like master limited partnerships, have long been a staple of income portfolios.  Because they are required by law to pay out 90 percent of their earnings as dividends, they can provide investors with high yields.  Since 2009, the price of equity REITs has more than doubled due to demand from yield-hungry investors who have been faced with a low interest-rate environment.

A downside of investing in REITs is that they are generally very sensitive to interest rate increases.  Since most of their earnings are distributed as dividends, REITs do not keep much cash on hand, so they have an ongoing need to raise cash by borrowing money or selling shares.  When interest rates rise, their cost of capital also rises cutting into their earnings.  The spectre of rising interest rates hit the markets hard in May, and from May 21 to June 21 the market value of equity REITs declined by about 16 percent.

So given the likelihood that interest rates will probably be rising in the next few years, which REITs should be avoided and which ones might still offer opportunities?

I would suggest avoiding those REITs that are saddled with long-term leases.  Owning such REITs is comparable to owning bonds – they provide steady and reliable cash flow through rents, but as inflation picks up and interest rates rise, the REITs cannot make appropriate rent adjustments to cover increased capital costs (and, of course, dividends may suffer).  Examples of business types with long-term leases include landlords of single-tenant (triple net-lease) properties and most healthcare REITs.  The one exception I would make here is if you come upon any REITs that issue leases with rent escalators rather than fixed rents.  Those might still be worth investigating.

The REITs that may prove to be smart investments for income would be those that hold relatively short-term leases. In particular, I would explore multi-family REITs and self-storage REITs.

 

Multi-family Residential REITs

Multi-family (apartment) REITs have underperformed other REITs lately.  An improving housing market and the number of new apartments coming onto the markets have scared many potential investors away.  However, as the economy improves, these REITs are poised for a comeback.  An improving economy means more jobs, which directly impacts these REITs by increasing the number of potential tenants.  As interest rates rise, building of new apartments is also expected to drop off significantly, thus allowing current landlords more flexibility to increase the rents of existing residents.

Two popular multi-family REITs to investigate are:

Equity Residential (EQR, yield 2.8%)
AvalonBay Communities, Inc. (AVB, yield 3.2%)

Another possibility within this sector is with a student housing REIT:

American Campus Communities (ACC, yield 3.6%)

 

Self-Storage REITs

The self-storage industry consists of about 55,000 properties nationwide.  Some people consider the industry to be a somewhat counter-cyclical, i.e., a troubled economy = increased need for storage.  The industry is currently experiencing record-high occupancy rates of around 90 percent, and landlords have been raising rents 5 percent or higher on existing tenants over the past couple of years.

Self-storage operators are benefiting from low competition because supply is tight.  There are only about 200 self-storage facilities currently under construction nationwide.  This compares with over 2,500 facilities developed between 2003 and 2007.  High valuations for self-storage properties are likely to persist until there is another wave of development that saturates the market.

Three popular self-storage REITs to investigate are:

Public Storage (PSA, yield 3.3%)
Extra Space Storage, Inc. (EXR, yield 3.8%)
CubeSmart (CUBE, yield 2.7%)

Please be sure to conduct your own due diligence on any of the REITs mentioned in this post before investing.  I am not recommending these as investments, only as possibilities to explore.  (Disclosure: I own none of the REITs mentioned in this post, but may purchase one or more of them after doing more exhaustive analysis over the next week.)