7/21/2015 | By Ralph Block
After spending dozens of hours poring over REITs’ recent financial information and listening to their first quarter conference calls, my belief in the health of America’s space markets has been confirmed: Occupancy rates are high, rents are up and property owners have more bargaining power. Supply – while increasing – isn’t at worrisome levels. Commercial real estate values, which underpin REIT stock valuations, are firm and rising moderately; investors of many types are enthusiastically bidding for good properties.
Yet, as of mid-May, REIT stocks were in negative territory for the year. The decline from the 2015 peak in late January was in the double-digit range. As a REIT investor for more than 40 years, I’ve rarely been so frustrated, and I’d venture to guess that a large number of REIT directors, officers and employees share my feelings. Why?
Investors own REIT stocks for various reasons, but most of us own them for predictable, stable and gently rising free cash flow – most of which is paid out in dividends. We also own them to participate in the fortunes of well-located and well-managed commercial real estate, which (including the underlying land) tends to appreciate in value over time.
But, based on the southerly direction of REIT stock prices from late January through mid-May, it would seem that investors don’t much care about favorable fundamentals. No, they are obsessed with the direction of interest rates and bond yields, even though the Federal Reserve seems to be cautious in its plan to bring shortterm rates up from zero. Bond yields, although slightly higher today, are still near historical lows.
There is some logic behind this reaction. Rightly or wrongly, REIT stocks – like utility shares – have always been regarded as “interest rate-sensitive” and thus likely to decline when interest rates and bond yields rise. REIT shares bear higher dividend yields than those of other equities, and some investors have bought them for this reason. REIT share prices may decline as yields of competing asset classes rise.
Also, while the evidence is mixed, there have been historical periods when REIT stocks have significantly underperformed during rising rate environments. A dramatic example occurred from the spring through the end of 2013, even though that period was short-lived. Meanwhile, REITs have always used debt capital to finance some of their property assets, and rising borrowing costs will impact earnings growth. Another concern, of course, is that higher interest rates and bond yields often negatively affect commercial real estate values.
It is intrinsic value that will drive the prices of REIT stocks over any meaningful time horizon.
Nevertheless, it is intrinsic value that will drive the prices of REIT stocks over any meaningful time horizon. The need of investors for current yield is no more important than total return, and the latter is heavily influenced by growth in free cash flow. Repeat after me: “REITs are not bonds!” Furthermore, REITs have done a great job of fixing debt costs and extending maturities. And, perhaps most importantly, commercial real estate prices are affected by many forces – interest rates and bond yields are only one of them.
REIT stocks’ intrinsic values will be a function of their underlying property values and their ability to increase free cash flows and dividends. So, although rising interest rates and bond yields will be a headwind from time to time, investors should maintain perspective and consider the favorable effects that strengthening cash flows, resulting from a stronger economic recovery, will have on intrinsic REIT share values.
Perspective is sorely needed in the investment world – perhaps more so now than ever before.
Ralph Block is the author of “Investing in REITs” and “The Essential REIT” blog. Views expressed are solely those of the author.
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