The iShares U.S. Real Estate ETF (NYSE: IYR), one of the largest exchange traded funds dedicated to real estate stocks and real estate investment trusts, is lower by more than 9 percent year-to-date.
Some of that laggard performance can be attributed to expectations that the Federal Reserve will continue raising interest rates this year. By some estimates, the Fed could hike borrowing costs four times in 2018, moves that could weigh on rate-sensitive, income-generating asset classes such as REITs.
While REITs often get lumped in the same rate-sensitive basket as telecommunications and utilities stocks, historical data suggest the real estate sector does not always swoon during Fed tightening cycles. One important point to remember is that there is a difference between lagging and outright downward spirals.
Treasury Yields Weigh On REITs
“U.S. REITS have been lagging broad U.S. equities,” S&P Dow Jones Indices said in a recent note. “During the recent climb in 10-year Treasury yields from the 2018 low of 2.41 percent on Jan. 2, to as high as 2.94 percent on Feb. 21, the Dow Jones U.S. Select REIT Index declined 11.2 percent. Though we have found that REITS have generally fared well over full cycles of rising rates, periods of sharper increases tend to weigh heavily on the minds of REIT investors.”
IYR tracks the Dow Jones U.S. Real Estate Index and holds 123 stocks. The ETF did lag the S&P 500 last year as the Fed raised interest rates three times, but IYR did finish the year positive. IYR gained 9.3 percent in 2017 compared to 21.7 percent for the S&P 500.
The type of REITs held by funds such as IYR is pivotal to the funds' performance potential, particularly in rising rate environments.
Shorter Is Better
Just as shorter term bonds fare better when long rates rises, REITs with short-term leases can be solid in the face of rising interest rates.
“REITs with shorter-term lease durations — apartments, hotels/resorts, manufactured homes and self-storage — have generally fared more favorably,” said S&P Dow Jones. “Theoretically, these REITs should be less sensitive to interest rates since they can reprice their rental agreements more quickly.”
IYR allocates over 12 percent of its weight to residential REITs and almost 5 percent to hotel REITs. The ETF has a trailing 12-month dividend yield of 3.84 percent.
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