Most REIT Funds Shine In Murky Market

February 21, 2014

Not all sectors are delivering as lackluster a performance as the S&P 500 in 2014.

The S&P 500 Index has been in the red much of this year, and is now fractionally lower year-to-date after a 30 percent run-up in 2013. But there are pockets of the market, such as real estate investment trusts, that have outperformed the broad benchmark.

These REITs and related ETFs, which are involved in residential, commercial, self-storage and health-care properties, have benefitted from the historic low interest rates fueled in part by an accommodative Federal Reserve that is keeping rates at near zero.

What's noteworthy is that despite the general outperformance, the sector doesn't move in unison. Different pockets of real estate are delivering different results, which is to say investors need to look under the hood and understand what exactly they are investing in.

Take for example these REIT-focused ETFs: The Market Vectors Mortgage REIT Income ETF (MORT), the Vanguard U.S. REIT fund (VNQ | A-88) and iShares FTSE NAREIT Residential Plus Capped ETF (REZ | B-75).

MORT, VNQ and REZ are up 8.03 percent, 8.16 percent and 9.42 percent, respectively, year-to-date. In that same period, the SPDR S&P Homebuilders ETF (XHB | A-24) actually slipped 1.11 percent. And the S&P 500 is now roughly 0.5 percent lower from where it ended 2013.

Chart courtesy of StockCharts.com

VNQ and REZ are compromised of stocks that, in turn, own real estate properties and generate income from rentals and property sales. As a rule, they must pass on 90 percent or more of their profits on to investors.

Since REITs borrow money to buy up properties, a rising-interest-rate environment would have a negative impact on their dividends if they have to pay more to borrow money in the short term. However, new Fed Chairman Janet Yellen is looking to make good on the stance of her predecessor, Ben Bernanke, by keeping short-term rates near zero to help buoy the slow economic recovery.

Mortgage REIT funds such as MORT, meanwhile, don't invest directly in properties, but borrow money based on short-term rates and use that money to buy long-term mortgages on real estate properties.

Rising interest rates will also hurt funds like MORT, which profit from the gap between short-term borrowing rates and what long-term bonds are yielding.

However, the current spread between 3-month T-bills (0.06 percent) and 10-year Treasury notes (2.75 percent) has not been this wide in the last 35 years, and that spread is expected to be in place for the foreseeable future, according to Tyler Mordy, president and co-chief investment strategist of Toronto-based Hahn Investments.

"The lifeblood of the MREIT [mortgage REIT] sector is the steep yield curve," Mordy told ETF.com. "Currently, the spread is good. For the next one or two years, MREITs are a phenomenal play."

In addition, Mordy said mortgage REIT stocks are currently cheap, trading at roughly a 20 percent discount to their book value.

So what's hurting home builder ETFs such as XHB, which invests in homebuilding and construction supplies stocks?

Well, new data from the Commerce Department this week reported that privately-owned housing starts in January were at a seasonally adjusted annual rate of 880,000, 16 percent below the revised December estimate of 1,048,000. That figure also represents a 2 percent year-on-year decline.

Also, single-family housing starts in January were at a rate of 573,000, or 15.9 percent below the revised December figure of 681,000.

The frigid weather can be partly to blame for the poor housing starts, as well as an economy that, after screeching to a loud finish in 2013, is sputtering along in the first two months of 2014.

 

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