The shares of real estate investment trusts (REITs) like Realty Income (NYSE:O), Avalon Bay (NYSE:AVB), and HCP (NYSE:HCP) have been struggling of late because of concerns that interest rates are set to head higher sooner rather than later. Rising rates aren't as bad as some believe for property owners, however, and that could spell a great buying opportunity -- but only if you're ready.
1. Hard assets
Interest rates remain near historic lows, artificially held there by the Federal Reserve. That's left investors reaching for yield. Since REITs are, by design, an income investment, yield-hungry investors have bid up the sector. However, talk of Fed action has sent REIT shares lower lately. That's just a hint of what might take place if the Fed actually does something.
However, step back and think about what a REIT is before abandoning this asset class. Avalon Bay owns over 270 apartment buildings for a total of more than 80,000 apartments. Better yet, these apartments are in high barrier-to-entry markets like New York, San Francisco, and Los Angeles. Owning Avalon Bay is a claim on physical property, hard assets, in key cities around the country.
They aren't building more land, and Avalon Bay's apartments are highly desirable. Inflation comes about when growth heats up, which is usually why the Federal Reserve starts to increase interest rates. So by its very nature, the underlying value of a REITs property will increase along with inflation, providing a natural hedge. That's particularly true for a high-quality portfolio like the one owned by Avalon Bay.
2. Lease renewals
So, the knee-jerk response to sell a REIT like Avalon Bay when interest rates move higher misses the longer-term picture. But it also misses a near-term issue: REITs regularly raise rents. Silver Bay (NYSE:SBY), the oldest of the publicly traded single-family REITs, increased rents by around 2% for leases that expired in the third quarter. That's a low sum because the company is focusing on increasing occupancy -- it plans on seeking larger increases in the fourth quarter and beyond.
The interesting thing is that 2% is about in line with today's low inflation. If interest rates and inflation pick up, Silver Bay and Avalon Bay will both be more aggressive in asking residents to pay more each month when their leases expire. So, throughout the year, REITs like these will be pushing through rent increases that will, effectively, offset the impact of inflation and the usually associated higher interest rates.
What about REITs like Realty Income that buy retail and business properties with long-term leases? No problem! The leases, which can last for up to 20 years, generally have contractual rent hikes built in. And the best part is that the rent hikes are usually tied to -- you guessed it -- inflation. So Realty doesn't even need to negotiate higher rates, they just happen. That gives the company, and similar triple-net-lease players, a leg up on REITs like Silver Bay and Avalon Bay.
3. Cheap debt
Another interesting feature of REITs is that, like other companies, they have been locking in low rates by issuing debt. For example, health care REIT HCP recently issued 10-year debt with a 4.25% coupon to replace maturing debt with a 5.65% coupon. As inflation pushes up its rent rolls, though, the interest rate paid on the new 4.25% debt won't change.
Thus, HCP has an inherent leverage to rising rates since rising rent rolls act to increase its profitability. That's true of HCP, but also of Avalon Bay, Silver Bay, Realty Income, and any other REIT that's lowered the interest rates it pays on long-term debt.
There's little doubt that REITs will hit the skids when the Fed starts raising rates. However, that could actually be a great buying opportunity for contrarian minded investors. The underlying dynamics of the sector suggest that any impact REITs feel on the business side will be short-lived. And that's why a sell-off could be a great long-term buying opportunity.
Reuben Brewer has positions in HCP and Realty Income. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.