Here's the Unvarnished Truth About REITs and Interest Rates

If you're following the crowd, you could be leaving millions on the table...

The U.S. Treasury 10-year yield has touched 3%, and everyone knows what that means.

As rates have begun to rise over the past few weeks, I've seen a steady stream of REIT-bearish commentaries across the web. Some of them are written in a "War of the Worlds," "the Martians have landed," apocalyptic tone.

"It is just a lose-lose proposition for REITs, and when rates rise, we must sell. It's time for REIT investors to sell! Sell now! No research, independent thought, or discretion needed - just sell immediately!"

You see, the "conventional wisdom" (an oxymoron, kind of like "military intelligence") holds that rising interest rates means falling real estate prices, so real estate investment trusts (REITs) are now... pretty much worthless.

Furthermore, this wisdom tells us that rising interest rates will make the dividend yields of REITs less attractive when compared with fixed-income investment opportunities, so they indeed must sell off to provide higher returns to new buyers. This line of thinking also holds that it will cost more for REITs to borrow money, which in turn will reduce the bottom-line profits.

Well, there's one big problem with all this conventional wisdom and what it's telling us about owning these investments right now...

It's all wrong. Dead wrong.

So if you happen to be tuned into the conventional wisdom, watching T-note yields creep up and dumping your REITs, or, if you don't own REITs, ruling them out as investments on the strength of this panic... you're making a mighty pricey mistake.

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A Little Math and a Bit of History Busts This Myth

In the most recent period of rising rates, between 2004 and 2007, the fed funds rate rose from less than 1% to over 5 % - that's nothing to sneeze at.

REITs handily outperformed stocks... by a two-to-one margin, no less. Indeed, in spite of all that conventional wisdom in the way, REITs rose by almost 80% while stocks, as measured by the S&P 500, returned less than 40%.

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If that's a "disaster"... bring it on.

Far from being a disaster for real estate, the improving economy that drove higher rates also drove REIT prices higher.

So you not only didn't lose money as a REIT owner, but you also did way better than those who owned the Holy Grail stock indexes.

This wasn't a one-time fluke, either.

At the end of 1975, the fed funds rate was 5.2%. By the end of 1980, it was over 19%. Again, that's a considerable increase.

I lived through it, so I can tell you that those years were not a great time for... just about everybody, really: OPEC embargoes, massive lines to gas up your car, Jimmy Carter's "lustful heart," economic malaise, and crushing stagflation.

Stock investors lived in their own special garden of misery then, too; the S&P 500 gained just 3.5% during that time. That's a ho-hum return at the best of times, but it gets even worse when you consider the corrosive effect of stagflation.

Again, accepting the conventional wisdom that REITs should be avoided in times of rising rates would have been an expensive mistake.

You don't have to take my word for it: According to the National Association of Real Estate Investment Trusts, equity REIT prices almost tripled during that time frame. Every dollar invested in equity REITs at the end of 1975 was worth $2.70 at the end of 1980.

Interest rates almost quadrupled to levels that would give today's LIRP- and ZIRP-addicted pundits and investors fatal aneurisms, and stocks struggled mightily, but - once more - REITs outperformed by a massive, convincing margin.

So how could the market's received wisdom on REITs be so wildly off base?

The reason is deceptively simple.

Here's What the Conventional "REIT-Bears" Are Getting Wrong

It is certainly true that rising rates make a fixed coupon investment, like a bond, automatically worth less.

But that is not the case with REITs.

In fact, the same improving economic conditions that prod central bankers to hike rates higher pretty much guarantee that REIT operating results and dividends are trending higher.

In fact, the payout for REIT shares may very well grow faster than rates rise, making them worth more, not less, as rates rise.

The notion that REITs face increased borrowing costs amid rising rates doesn't hold up to scrutiny, either.

REITs have been deleveraging over the past few years, and total leverage in the industry is at the lowest level in the last 20 years right now. Most REITs have taken advantage of the lower rates that have been in place for several years now to lock in low-cost, fixed-rate financing.

Cheap money is already baked in. Rising rates will not cause a spike in interest costs that destroy REIT earnings. In fact, rising rates are likely a non-event for most REITs.

Now... let me show you my math. Or, more accurately, somebody else's math; I stole the finding.

Sam Diedrich, director of alternatives and risk management at Brookfield Asset Management Inc. (NYSE: BAM), crunched the numbers and reported the result in a column for Forbes last year.

He ran a regression analysis of 10-year U.S. Treasury futures and the MSCI US REIT Index (RMZ) that found almost no relationship between the two. Rather than revisiting Statistics 101, let me tell you what he found.

When a stronger economy is slowly moving rates, higher REITs tend to outperform because of improved fundamentals. Occupancy rates and rents are moving higher, dividends are rising, and the share prices move higher based on strong economic activity.

However, when there's a "system shock" that drives rates higher very rapidly, it is, in fact, bad for REITs.

Under those conditions, REIT prices do fall. Investor panic and misconceptions seem to be the driver of the price decline, but the really interesting thing is that, historically speaking, the collapse tends to correct relatively quickly.

Conventional wisdom says to sell REITs. Most of the time, higher rates portend better times ahead for REIT investors.

When we get a rate spike that knocks REITs lower, it's almost always a massive buying opportunity; a quality equity REIT is definitely a true "buy the dips" kind of investment.

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About the Author

Tim Melvin is an unlikely investment expert by any measure. Raised in the "projects" of Baltimore by a single mother, he never attended college and started out as a door-to-door vacuum salesman. But he knew the real money was in the stock market, so he set sights on investing - and by sheer force of determination, he eventually became a financial advisor to millionaires. Today, after 30 years of managing money for some of the wealthiest people in the world, he draws on his experience to help investors find "unreasonably good" bargain stocks, multiply profits, and build their nest eggs. Tim tirelessly works to find overlooked "hidden gems" in the stock market, drawing on the research of legendary investors like Benjamin Graham, Walter Schloss, and Marty Whitman. He has written and lectured extensively on the markets, with work appearing on Benzinga, Real Money, Daily Speculations, and more. He has published several books in the "Little Book of" Investment Series and a "Junior Chamber Course" geared towards young adults that teaches Graham's principles and techniques to a new generation of investors. Today, he serves as the Special Situations Strategist at Money Morning and the editor of Peak Yield Investor.

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