In this video clip from "Ask Us Anything" on Motley Fool Live, recorded on Feb. 28, Fool.com contributors Matt Frankel, Dan Caplinger, and Nicholas Rossolillo answer a member's question about whether now is a bad time to add REITs to a portfolio with interest rates rising or would it be better to wait until the current volatility subsides.
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Matt Frankel: Higher interest rates can affect REITs in two main ways. One is a secondary way, it makes their funding tougher or more expensive. Most REITs require or depend at least on some borrowed money to finance their growth strategy, like how real estate investors take out mortgages to buy properties, same idea with REITs. As interest rates rise, those get more expensive it adds to their cost of capital.
No. 2 and more significantly, income stocks like REITs their yields generally move in tandem with risk-free rates. Specifically, the 10-year treasury is a really good benchmark. As treasury yields rise, investors expect that risk premium meaning the difference between what they can get on a risk-free investment, and a so-called risky investment, like a REIT to roughly stay the same.
As REIT yields get pushed higher by rising rates, yields and share prices have an inverse relationship, so it puts pressure on their stock prices. All that said, as I said at the top of the show, it's all about expectations. Right now the expectation is that the federal funds rate is going to rise to roughly two percent by next year.
If that holds true, it wouldn't really have that much of a detrimental effect on REITs because that's what the market's expecting at this point. Keep an eye on that, it's never really a bad time to buy REITs because as Dan mentioned, they're not just income stocks, there's that growth element as well, they're meant as total return investments.
Historically, they tend to hold up really well during inflationary periods. They don't necessarily tend to beat the market like they do during low inflation and low-interest rate times, but they tend to hold up quite well during inflationary environments, and a lot of that is because their property values keep up with inflation. Rent keeps up with inflation, things like that.
So it's not just a question of what it does to their income, there are also pretty inflation-protected growth investments in that way. It's not a bad time to buy REITs. You could definitely see them come under some volatility, especially if interest rates don't perform as expected, but they're still the biggest component of my portfolio, and I don't plan on changing that.
Dan Caplinger: Nick, I know that you've got some experience in the real estate area as well. What thoughts do you have on that REIT question from Fig?
Nicholas Rossolillo: Actually, the only thing I would add is just what Matt said, the very last sentence Matt just said, I don't plan on changing anything right now. There's been a lot of questions in the last few weeks for good reason about not just REITs, adding to REITs right now, but dividend stocks in general.
I would just say this to investors, a lot of investors had a bad 2021 they were heavily invested in these growth stocks that are getting beat up, the last two months have been just icing on the cake, and so the temptation is to now change your investment strategy and suddenly just dump money into value stocks, into REITs, into dividend payers.
I think that could be a mistake. If you invest in growth stocks with a long-term time horizon, don't change your strategy to a more "conservative investment strategy" after the market has just been completely beat up. The same is true, we tell people the same thing, when the market is super euphoric like it was in 2020, a lot of investors start ratcheting the risk up and they want to buy more and more and more of the stuff that's just flying high.
Resist that temptation on both ends of the spectrum, like after your portfolio has been completely obliterated. If you want REITs for the long-term, invest in REITs, but don't do it just because you just got beat up by the market. I think that can be a mistake that investors fall into when the market eventually makes a rebound, now I need to ratchet my risk backup and buy more growth stocks.
Just figure out where you're comfortable investing for the long run and just keep doing more of that and just ride out these ups and downs in the markets. I guess that's my comment on REITs.
