Why You Should Stay Away From REIT ETF's For Just A Little Longer

Last week the Federal Reserve once again announced they would not be raising interest rates. To many on Wall Street this was good news; cheap money would continue to be available, thus making it more affordable to borrow money to grow business's and spur economic activity.

But there is a downside to continued low interest rates which comes in the form of uncertainty about when rates will increase and how those increases will affect economic activity and mainly businesses that are directly affected by interest rates. When we look at who is most affected by rising rates, the finance sector is of course first to come to mind; banks and other lenders, but also the real-estate industry.

Whether it be individuals or businesses buying and selling homes or property rising interest means the overall cost of buying and owning that property increases, because of the higher interest rate the borrow will have to pay.

This is the first issue with owning REIT's during a rising interest rate environment. In order for most REIT's to purchase new property, they will need to borrow money. When rates are high, that borrowing becomes more expensive, thus limiting the amount of new property a REIT may be able to afford.

Furthermore, since REIT's often borrow large amounts of money, in order to get a better interest rate today, they may have borrowed some or all of it with a floating interest rate. When rates stay the same for a long period of time, as they have for the past few years, this does not become an issue. But when rates start to move, especially higher, the floating rate will increase and put stress on the business.

In some cases, a REIT with rising interest rate cost could even be the force to sell income generating property in order to lower its debt load. The issue with that is then there is less income coming into the REIT, meaning less can be paid out in the form of a dividend to investors. And since most REIT investors own the REIT simply because they offer high dividend yields, a falling dividend can and will cause many investors to sell as they find greener pastures elsewhere.

That leads to the next issue with owning REIT's during a rising interest rate environment. Since the REIT must pay out 90% of its taxable income to investors, high yield investors are drawn to REIT's during low-interest-rate periods because better options are limited. But when Treasury yields rise, unless REIT dividend yields are substantially higher, the risk of owning a REIT becomes greater and no longer makes sense.

For example, if the 10 Year US Treasury Bond is paying 4% and a REIT is paying 5%, the 1% difference doesn't adequately reward the investor for the risk they are taking with the REIT, which doesn't have a guarantee to pay that 5% yield. On the flip side, the US Treasury Bond is backed by the US Federal Government and has its guarantee stamped on it to pay the investor that 4% yield, regardless of what happens with the economy.

During past interest rate rising environments though, REIT's have surprisingly done well. Some people contribute this to the fact that the Federal Reserve only raises interest rates when economic activity is improving, and, therefore, real-estate values and more importantly for REIT's, rent rates are rising. If rental rates increase, more income is coming, in which can then be passed to investors through the REIT's dividend.

But, rates aren't expected to make a dramatic increase in the near future, which will likely hurt REIT's in the coming months. In May The National Association of REALTORS predicted national office vacancy rates would decrease by 0.1% over the coming year, industrial space would decrease by 0.3% and retail space would shrink by 0.4%. Furthermore the NAR chief economist Lawrence Yun stated "The commercial real estate sector is on the path to recovery, but subpar economic growth, lack of financing available to small investors and the industry trend towards squeezing more employees into existing spaces will keep demand from meaningful acceleration."

The lack of demand for space would point to the idea that rental rates are increasing, in the near term, is unlikely. And without higher rental rates, REIT's are unlikely to be able to pay higher yields unless they acquire new property's, which means they would have to take on more debt at higher rates.

Buying into a REIT today doesn't seem like a smart move. The risks just don't outweigh the rewards and based on the way the market has treated the REIT ETF's; I am not the only one that thinks this way.

Of the 20 Real-Estate ETF's I found after running a screener, not one is in the black over the past month. More so, only two are up over the last three months; iShares International Developed Property (WPS) and Wisdom Tree Global Ex-U.S. Real Estate (DRW), both I might add are more focused on property's outside the US.

At the end of the day, owning REIT's can be very profitable, but like most industries the world of real estate is cyclical and it would appear that industry as a whole is currently still in the trough of the cycle. Wait for rental rates to begin rising and the more leveraged or rate sensitive REIT's to show their hands before buying into the industry.

Matt Thalman
INO.com Contributor, ETFs
Follow me on Twitter @mthalman5513

Disclosure: This contributor did not hold positions in any company mentioned above. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.