Reuters

(Reuters)

Rising Interest Rates Won't Necessarily Derail Real-Estate Funds

Mutual Funds Associated Press

The threat of rising interest rates is raising real fears about real-estate mutual funds.

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Investors have pulled money out of real-estate funds for two straight months, even though they remain among the year's best performers and pay bigger dividends than many stock funds. The worry is that rising rates will hurt growth for the owners of apartment buildings, offices and other commercial real estate, as well as limit demand for their stocks.

Before joining the crowd, bear in mind that rising rates don't always mean losses for real-estate funds. Many have delivered solid returns even during periods of rising interest rates. The key is how quickly and how high rates rise. Real-estate fund managers say they can still make money for investors, though they acknowledge that the performance won't be as good as this year and the recent past.

"One of the things you have to ask is why are rates rising," says John Wenker, co-portfolio manager of Nuveen's Real Estate Securities fund since 1999. "If rates are moving up moderately because the economy is starting to strengthen, that's fine for commercial real estate."

BUILT DIFFERENTLY

For real-estate funds, dividends are king. Most invest in real-estate investment trusts, which can avoid income taxes if they pass on 90 percent of their profit to shareholders as dividends. REITs can own shopping centers, self-storage units or senior housing communities.

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Because they pay out so much of their income as dividends, REITs attracted income investors who grew tired of the low yields offered by bonds. That demand helped the average real-estate fund return an annualized 17.4 percent over the last five years, according to Morningstar. That beats the 15.6 percent annualized return for the Standard & Poor's 500 index over the same time.

One concern for REITs is that a rise in interest rates, which economists say is inevitable, will push investors to dump them and go back to bonds. Higher interest rates also make it more expensive for REITs to raise money to buy and develop real estate.

Those fears hurt REITs last year, when the Federal Reserve hinted that it may curtail its bond-buying stimulus program. The yield on the 10-year Treasury note quickly jumped from 1.63 percent in early May to nearly 3 percent by the end of the year. That drove the average real-estate fund into the red in the last three quarters of 2013. For the year, the average real-estate fund returned just 1.5 percent, versus 32.4 percent for the S&P 500.

GRADUAL IS GOOD

REITs can deliver gains if the increase in rates is more moderate and the result of an improving economy. In such a scenario, fund managers say property owners should be able to charge higher rents and have fewer vacancies for their apartments and office buildings. That would lead to higher dividends.

The economy hasn't been as strong as many had hoped, but it is improving. Many economists believe growth next year will be the strongest since 2005. The unemployment rate is also at its lowest level since 2008, and the job market is strong enough that the Federal Reserve earlier this week announced the end to its bond-buying program. The central bank could begin raising its target for short-term interest rates next year, and many economists expect a measured rise.

An encouraging precedent for real-estate investors is the period of 2004-06, when the Federal Reserve raised short-term rates 17 times and the yield on the 10-year Treasury note gradually rose from 4.62 percent to 5.20 percent. The average real-estate fund had solid returns in each of those years, though the group suffered big losses in the following two years as the housing market slumped.

FAIR EXPECTATIONS

Even proponents of REITs acknowledge that they no longer look cheap following their strong run the last five years. The largest U.S. REIT, mall-operator Simon Property Group, has jumped more than sevenfold since bottoming in March 2009. The rise in price has helped push its dividend yield down to 2.9 percent. It was above 4 percent as recently as early 2010.

One of the biggest traditional threats to REITs, an overabundance of properties, isn't much of a concern, says Bob Zenouzi. He is a portfolio manager of the $5.7 billion Delaware Diversified Income fund, which can invest in various stocks and bonds and has more than 7 percent of its portfolio in real estate. Construction on new projects has remained relatively subdued, though some pockets of concern exist around the country, such as apartments in Washington, D.C., and other areas around the Southeast.

So what kinds of returns are likely in the future? REITs currently offer yields of 3 percent to 4 percent, and managers expect continued growth as the economy improves. Add that to expectations for inflation to remain relatively tame, and Zenouzi says an annual return in the high single digits is likely. Nuveen's Wenker has a similar forecast, suggesting something between 5 percent and 10 percent in the next 12 months.

Those returns, though, will likely also be less steady than they've been in recent years. Many investors continue to see REITs as being very sensitive to interest rates, regardless of their history, Wenker says. That could cause them to abandon the group when rates are rising, leading to volatility in REIT prices.

If a storm strikes, fund managers say to stand strong and invest for the long term.