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Consider REIT ETFs as Rates Rise?

This article was originally published on ETFTrends.com.

Yield hunters typically dump real estate investment trusts and sector-related exchange traded funds when interest rates rise, but REITs may do well in a growing economic environment that is also comes with higher interest rates.

Similar to other high-dividend payers, REITs are sensitive to rising interest rates since their yields look relatively less attractive to safer fixed-income alternatives. However, during a rising interest rate environment, the economy is typically expanding, so REITs may do well for another reason.

"If interest rates are going up because the economy is improving, that can be positive for REITs because landlords can raise rents to cover the rate increases," Brian Cordes, a senior vice president at Cohen & Steers, told CNBC, projecting the U.S. economy to grow by 2.9% this year. "We see the recent pullback as an attractive entry point to the asset class."

REITs have recently pulled back in light of the recent Federal Reserve rate hike speculations. Consequently, investors may find that this segment of the market looks cheaper than they use to. Year-to-date, the Vanguard REIT ETF (VNQ) fell 5.0%, iShares Dow Jones US Real Estate Index Fund (IYR) dropped 3.7% and Schwab US REIT ETF (SCHH) declined 3.6%.

Additionally, investors may consider the iShares Residential Real Estate Capped ETF (REZ) as a targeted REITs investment option that focuses on residential REITs, which can capitalize on higher residential rents.

Consider Overall Benefits of REITs

Cedrik Lachance, director of U.S. REIT research at Green Street Advisors, also argued that investors need to consider overall returns on their investments rather than just the current yield. For instance, the unlevered total return expectation of REITs are now trading 30 basis points lower than high-yield bonds versus an historical average of 60 basis points, which suggests REITs are slightly undervalued when compared to speculative-grade debt.

"REITs are not wildly cheap versus corporate bond alternatives, but they are somewhat attractive," Lachance told CNBC.

Furthermore, REITs may look cheapest relative to the value of their underlying real estate holdings. The REITs segment has historically traded at a 3% to 4% average premium over net asset value of underlying real estate holdings, but they are now trading at an average discount of about 9%.

For more information on real estate investment trusts, visit our REITs category.