Let me identify three promising areas where investors can go hunting.
Real Estate Investment Trusts (REITS) You don�t have to look very hard to see the relationship between higher interest rates and lower REIT prices. The Morgan Stanley REIT Index ($RMS.X, news, msgs) peaked on April 1 and then went into a slide on fears of higher interest rates that chopped 19% off the index by May 10. However, when the yield on the 10-year Treasury note actually fell and then stabilized in the weeks leading up to June 28, the index and REIT prices rallied to climb 14%. As the Fed�s June 30 meeting approached, however, the index dipped again, falling 1% on June 29 and 30.Check out your options. Find the best rate before you borrow.
That kind of extreme sensitivity to interest rates makes sense for most of the REIT sector. Investors buy REITs because they yield more than Treasury notes, so anything that raises the yield on Treasurys creates more competition and price pressure on REITs. That�s especially true when REITs trade at a premium to their net asset value (NAV), the value of the real estate that the REIT owns. Historically, REITs have traded at a 2% premium to NAV, according to Merrill Lynch, but that premium had climbed to 19% at the beginning of 2004 as investors were willing to pay higher prices for REITs in their quest for higher yields.
A couple parts of the REIT sector may actually do better if interest rates tick up modestly because the economy is growing strongly. Office REITs, for example, should see higher cash flow as the economy increases the demand for office space. Professional investors have already recognized this, bidding up the prices of office REITs to high premiums over NAV.
The same logic applies to apartment REITs where premiums to NAV are much more modest and which stand to get an extra boost as higher interest rates turn some homebuyers into home renters. The apartment sector is in the early stages of quite a turnaround. The first quarter of 2004 saw rising effective rents for the first time since 2001. Current trends show new demand outpacing new supply by the end of 2004, which should drive occupancy rates to 95% by the end of 2005 from 93% in the first quarter of 2004, according to projections by Bear, Stearns & Co. Effective rents will climb 4.5% in 2005, Bear, Stearns calculates.
A couple of top-quality apartment REITs now trade at relatively modest premiums to NAV and, if the sector pulls back again, investors could see a return to the discounts to NAV that these stocks showed in May. Equity Residential (EQR, news, msgs) traded at $29.73 at the close on June 30, a 14% premium to the $26.19 that Merrill Lynch calculates for the REIT�s NAV. But Equity Residential traded at $27.29 on May 19, just a 4% premium, and the price could easily retreat to that level again. The yield is 5.9%. Another apartment REIT to watch is Archstone-Smith Trust (ASN, news, msgs). The REIT closed at $29.33 on June 30, an 8% premium to Merrill Lynch�s estimated NAV of $27.24. The REIT traded at $27.23, a penny below NAV, on May 19. The yield is 6%.