REITs (real estate investment trusts) are trading at a discount to their net asset value, as investors worry about the impact of rising interest rates, but this low valuation may underestimate earnings growth driven by the economic recovery.

REITs

Impact of interest rates on REITs

“REITs enter 2014 beaten down from both the perception and overhang of higher interest rates. Many stocks now trade at clear discounts to NAV,” writes Citi analyst Michael Bilerman. “The underperformance on interest rate concerns is only temporary and will soon be offset by the continued positive impact that a strengthening economy can have on commercial real estate in… it should be just a matter of time for capital, both public and private, to ‘come back’ to the REIT space.”

In addition to the knock-on effects of the economic recovery, such as increasing rents, the new supply of REITs is currently low and Bilerman thinks there is room for ‘generalist’ investors to start allocating more of their portfolio to REITs, providing additional price support.

Rising interest rates are a concern

Bilerman acknowledges that rising interest rates are a concern, and if rates go up faster than expected or the economic recovery stalls out then his bull case might not come together. But since current REIT prices already seem to reflect the bear case, the downside to investing is pretty low. Whether he looks at NAV growth or dividend yields plus AFFO (adjusted funds from operations) growth, he reaches the same conclusion of 5 – 10% returns over 2014, assuming about 7% AFFO growth and 4% dividend yields.

nav growth reit return

dividend affo reit return

Important to look at interest rate exposure as a whole

Of course, another reason that some investors may be staying away from REITs is simply that they don’t want to increase their overall interest rate exposure, even if the asset class itself looks attractive. One of the big lessons from the economic crisis has been that it’s not enough to diversify asset holdings, you also need to diversify underlying risk factors or a single unexpected change could wipe out what looks like a well-constructed portfolio. So even if you think REITs are attractive compared to equities, or some other asset, it’s important to be sure they are attractive when compared to other types of interest rate exposure.