Lagging REIT & Utility ETFs At Crossroad

February 27, 2018

Economy Matters

Like utilities, the real estate sector has gotten hit hard this year on the back of rising interest rates. Yields on real estate ETFs, such as the aforementioned XLRE, have become less attractive to some investors in this year’s higher rate environment. XLRE, which primarily holds real estate investment trusts (REITs), currently yields 3.5% as well.

Higher rates also make financing more expensive for REITs, which typically own, operate and lease real estate properties.

That said, interest rates shouldn’t be looked at in a vacuum when it comes to real estate, according to Alexander Goldfarb, senior REIT analyst at Sandler O’ Neill.

“REITs are a derivative of credit and the economy. It’s not just where interest rates are going, it’s also what’s happening with the economy,” he remarked.

Goldfarb says that if interest rates are rising for the right reasons―namely, stronger economic growth― that could actually bode well for real estate stocks.

“The question is, do we get sustained economic growth at or above 3%? If that’s sustained and that’s why interest rates are going up, REITs should start to gain traction mid-to-later this year as the ripple effects flow through: businesses expand and need more office space; consumers feel more comfortable so they shop more; and retailers do better, so that translates into more store reinvestment,” Goldfarb explained.

On the other hand, he notes that if there are inflation concerns without a parallel increase in the economic backdrop, that would be seen as negative for REITs, because you would start down the worrying path of inflation without a commensurate economic growth.

Key 3% Level

As with utilities, the pace and magnitude of any interest rate changes matters, too.

Matt Kopsky, REIT analyst at Edward Jones, believes that “REITs will perform well in a stable to moderately rising 10-year environment, but will likely underperform if the 10-year yield continues moving higher to 3%-plus.”

REIT “fundamentals are still healthy and valuation levels look attractive. For long-term investors, we believe the REIT sell-off makes an attractive entry point. However, in the near term, it’s all about interest rates, and that’s difficult to predict,” he added.

Follow Sumit Roy on Twitter @sumitroy2

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