(07/24/15) Contrarian Opportunity in REITs

Faced with the prospect of an imminent rate hike, many investors have given up on real estate investment trusts (REITs), mistakenly assuming that they’ll underperform as the cost of money goes up, suggests Keith Fitz-Gerald, editor of Total Wealth.

I can’t think of a more expensive mistake. Contrary to what a lot of people believe, REITs have historically done well when the cost of money is increasing.

Between 1994 and 2013, for example, there were nine time periods when interest rates rose by more than 1% (or 100 basis points in trader speak) as measured by the 10-Year US Treasury note. Six out of nine of those times, REITs provided positive returns.

Put another way, REITs made money when the markets experienced rate increases that were four times larger than the 0.25% boost the Fed is reportedly contemplating. Since 1994, there have been nine instances when rates rose by 1% or more and real estate did just fine.

What most people are missing, though, is that there’s a big difference between a sharp rate spike in the mold of Chairman Paul Volker’s 1970s “torpedo” and the slowest interest rate normalization in history that’s likely Yellen’s legacy.

The former is a mechanism designed to shut down inflation and rein in speculation, while the latter is intended to maintain all the things policy makers believe it makes possible, improving employment, consumer spending, and overall demand.

Mortgage-based REITs—that is those investing mainly in agency-backed securities—are going to come under the most pressure when rates rise.

That’s because the value of the fixed income investments they hold will decrease as rates go up. The reason is that yields of existing holdings will match or be inferior to newly issued alternatives with higher coupon rates.

Equity-based REITs—those investing in income-producing properties—are less sensitive to increasing rates. That’s because there’s usually plenty of cash flow and appreciation to offset any price drop associated with higher rates. Not always, mind you, but enough that it’s a good rule of thumb.

Consider Alexandria Real Estate Equities (ARE). The company deals heavily in tech real estate in New York and San Francisco among other places.

It taps into the explosive Unstoppable Trend of technology using a very innovative cluster model that groups investments immediately adjacent to world class academic, medical, and technology institutions.

The model exploits the logical strength associated with the world’s most sophisticated biotech companies, medical researchers, product development, and even biofuels, all of which are highly secure lessees, not the fly-by-night, perennially-unprofitable tenants you get in lesser REITs.

Or, consider Omega Healthcare Investors (OHI). The Maryland-based company invests heavily in hospital properties and healthcare facilities, with a special emphasis on nursing facilities. In fact, it recently acquired Aviv REIT, another significant player in assisted-living.

OHI’s nursing home concentration plays nicely with not one but two Unstoppable Trends—medicine and demographics—at a time when an estimated 10,000 baby boomers retire each day in America.

Like ARE, OHI has high-quality tenants representing a fraction of the risk associated with traditional office or residential tenants. And like ARE, OHI recently raised its dividend, increasing it by 8% year-over-year and resulting in a current yield of 6.1%.

OHI is cheap after the haircut so many REITs have seen in 2015 and it currently trades at a PE ratio of just 22, which strikes me as great value for a company that’s expanding its holdings at a time when Obamacare means more money flowing into all manner of healthcare facilities.