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Everything seems to be going wrong for real estate investment trusts, or REITs. The Vanguard REIT ETF is down nearly 20% from 2012 highs. However, it may not be the right time to sell your investments in the sector. It could actually be an incredible opportunity for long-term minded investors.
The good times never seemed so good
In May of this year, the REIT industry was rapidly approaching historic highs. The Vanguard REIT ETF, which holds a broad array of REITs, came within several percentage points of all-time highs.
A key metric for the industry, the 10-year Treasury rate, was drifting under 1.75%, heading toward the 1.53% historical low. Such low interest rates allowed REIT companies to borrow money for virtually pennies and invest in new properties. Nothing seemed like it could derail the engrossing success of these Wall Street darlings.
The tides shift, rapidly
In mid-May, the Vanguard REIT ETF topped out near $80, and ever since then, it's been falling. In just three months, the ETF has declined over 15%.
During the same days in which the REIT industry began to tumble, interest rates began to rise. Bottoming out at 1.66% on the 10-year Treasury early in May, interest rates have been rising ever since. The 10-year Treasury rate currently sits at 2.9%.
Why interest rates matter to REITs
Interest rates are paramount to REITs. Increases in interest rates heighten borrowing costs for REITs and hinder the industry's ability to expand. In essence, higher interest rates make it more expensive to acquire properties and, in turn, cuts into profits.
Furthermore, interest rates indirectly affect REITs through the companies' dividends. REITs are highly desirable for their attractive dividend yields and safe nature, acting as an alternative to bonds for many investors.
When rates rise, REITs' dividend yields are forced higher as their yields must trade at a premium to yields offered by treasuries and other bonds to compensate for the additional risk associated with REITs. And the only immediate way to raise REITs' dividend yields are to reduce the stock prices.
Where interest rates are heading
With interest rates being so vital to REITs' future, investors want to know: Where are they heading?
Richard Clarida, global strategic advisor at PIMCO, believes rates will be lower at year-end than where they are at the moment. He says markets are pricing in that the Fed will reduce its asset purchases by $20 billion in both September and December, and anything lower than that will send rates plummeting.
Jessica Hind of Capital Economics, an economic research firm, forecasts the 10-year Treasury rate declining to 2.5% by year-end. She noted, "We think investors may have run ahead of themselves. After all, even if the Fed does start to scale back its bond purchases in September as we expect, interest rates will remain very low for an extended period of time." The Fed has long said it will keep rates at ultra-low levels until unemployment hits 6.5%.
Opportunity is knocking
If the assumption that interest rates will remain historically low for an extended period of time is correct, substantial opportunities are presented in the REIT sector. Even the best-run REITs have been pulled southward with the overall industry. Realty Income (NYSE: O ) , Ventas (NYSE: VTR ) , Simon Property Group (NYSE: SPG ) , and Equity Residential (NYSE: EQR ) are all leaders in their respective sub-sectors of the real estate market, pay out dividend yields above 3%, and possess a debt to equity ratio under 1, demonstrating the manageable size of the companies' debt loads.
Furthermore, rising interest rates is not all bad for REITs. Rising rates are a traditional sign of improving economic conditions, which in turn would result in the companies' occupancy rates rising.
What could go wrong
Wall Street's belief that the Fed tapering asset purchases is the first step to eventually unwinding its balance sheet has contributed to the rise in interest rates. The Federal Reserve now holds over $3.6 trillion on its balance sheet, compared to $880 billion at the start of 2008. When and if the Fed finally begins to sell treasuries, the selling pressure could lead to soaring interest rates, which could cripple REITs. But according to most economists, unwinding is well down the road.
Moreover, historically speaking, the 10-year Treasury rate would still have to rise nearly 2 percentage points to reach the 4.64% average since 1871, leaving plenty of room for rates to run.
The Foolish bottom line
The REIT industry has been crippled by rising interest rates over the past three months, but leading industry analysts see the 10-year Treasury stabilizing, and possibly declining through the rest of the year. Over the long term, the Fed has consistently insisted that it will remain accommodative, and the unwinding of its massive balance sheet is probably years away. By the time interest rates do begin to rise, economic growth will hopefully be one of the reasons behind the increase and should offset some of the negative effects of high interest rates for REITs.
Given the recent pullback in REITs, now may be the opportunity to buy, not sell, the diversified leaders of the REIT industry, all of which pay out dividends over 3%. Out of all the trailblazers, Realty Income appears to be the most intriguing, with a dividend yielding over 5% and a real estate portfolio that's grown 151% over the past decade.
Looking toward the future, investors should look for a stabilization of interest rates and comments from the Fed to dictate their investment strategy.
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