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These Rebounding REITs Are a Smart Play for Investors

Although the Federal Reserve's statements at last month's Federal Open Market Committee meeting renewed the likelihood of an interest rate hike by the end of the year, real state investment trusts are attracting investor attention again.

Because REITs own and usually operate income-producing real estate and can be sensitive to fluctuations in interest rates, most observers thought REITs would suffer in an environment of rising interest rates in 2015. Weakness in REITs was particularly pronounced in August, just ahead of the September FOMC meeting, when a rate hike was widely anticipated. But the Fed took no action, and REITs enjoyed a rebound.

So far this year, the MSCI U.S. REIT index is up 2.39 percent, having rebounded from the third-quarter loss of 4.26 percent. The yield is 4.13 percent.

The Fed is now considering an interest rate hike in December, but financial advisors say there are good values in REITs, particularly in certain areas of the sector.

Higher interest rates are not always a problem. David Rodgers, senior real estate research analyst for the Milwaukee-based firm Robert W. Baird, says the knee-jerk assumption that rising interest rates hurt REITs is common. "There is an argument to be made that rising rates are not good for real estate. We all make the argument as well, but you have to consider a couple of different factors."

When the Fed eventually raises rates, it will be "in tandem with some healthy fundamentals -- increasing rent growth, inflation in the underlying assets. ... Once that does come, REITs will rise with rising rental rates," he says.

Furthermore, Rodgers says, given concerns about deflation in other parts of the world, it's hard to believe the U.S. will see runaway inflation.

And an interest rate hike is not a forgone conclusion by everyone. Ethan Penner, managing director of Mosaic Real Estate Investors in Los Angeles, says he expects no rise in interest rates any time soon because the U.S. economy is lethargic, the global economy is fragile and there are high government debt levels. "There is no way rates are going higher," he says.

The ABCs of REITs. Penner says the downdraft all REITs felt earlier this year was indiscriminate, punishing some names more than necessary. Part of that reason comes from people not understanding the nuances of the sector.

"There's always been a big misunderstanding on the different types of REITs," he says.

Some REITS, like the mortgage REIT Annaly Capital Management (NLY), are more like bets on the interest-rate yield curve, Penner says. "It owns assets and finances them with short-term debt. As long as the short-term rates stay low, they will make a lot of money. That has nothing to do with real estate," he says.

Penner says investors also need to know the difference between residential mortgage REITs and commercial mortgage REITs.

"Depending on your perspective of the economy, different properties perform differently. The apartment REIT that services lower- and middle-income apartments that have rents that reset every year will behave differently than an office or a shopping center REIT that owns high-end property and [has rents that] reset every five to 10 years," he says.

Hot REITs to buy. Because investors sold off REITs en masse, there are some bargains, Penner says. "It's a good time to think about buying REITs and has been for about three months," he says.

He likes Starwood Property Trust (STWD), which has a dividend yield of 9.36 percent, and Blackstone Mortgage Trust (BXMT), which has a dividend of 7.78 percent. He says both are "fantastic investments."

Penner says he's less enthused about office spaces and malls. "They're more vulnerable to a slower economic period where we [will be] mired in globally for some time," he says.

Melinda Kibler, certified financial planner with Palisades Hudson Financial Group in Fort Lauderdale, Florida, is also a fan of REITs. "We're long-term investors in REITs, and we think they are very valuable in a total portfolio. We suggest a 5 to 10 percent exposure to REITs in the equity allocation because there are many times that they can outperform the broader market, and they have lower correlation to other asset classes."

She says her office devotes one-third of the REIT allocation to international exposure and two-thirds to the U.S.

For the U.S. exposure, she says she likes the Vanguard REIT ETF (VNQ), an exchange-traded fund with a yield of 4.14 percent, or the Vanguard REIT Index (VGSLX), a mutual fund with an 8 percent yield. For international exposure, she says she prefers Fidelity's International Real Estate mutual fund (FIREX).

Rodgers says the Robert W. Baird firm upgraded its view on REITs in July. Areas the firm likes best are apartments, hotels, data centers, storage and industrial REITs.

In the industrial and data center space, Rodgers says he likes Prologis (PLD), with a yield of 3.37 percent. About 70 percent of its holdings are in the U.S., and the vacancy rate in the industry is pushing 6 percent on a national basis, he says, which is getting near an all-time low.

He also likes CoreSite Realty Corp. (COR), which has a yield of 3.02 percent. "It's a small-cap name and is growing 20 to 25 percent a year. It's very network-centric, co-location heavy, which is a side of a business we prefer," he says.

Rodgers says the stock performance for industrial REITs continues to struggle, which is at odds with what's going on in the sector: "From a fundamental perspective, what we're seeing is some of the best growth in industrials that we've ever seen in the industry, certainly going back 15 to 20 years."

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