It’s a challenging time for investors who want to maintain a diversified, income-oriented portfolio.

Higher US interest rates appear to loom on the horizon, although bond yields in most of the developed world are low and some central banks continue to pursue easing measures. Potential inflation is a concern in the United States, given the Federal Reserve’s six-year history of manufacturing money through quantitative easing (QE) (which lasted from 2008 through 2014).

Wilson Magee, director of global real estate and infrastructure securities, Franklin Real Asset Advisors®, believes this environment is causing many investors to search for alternative investments that can add an income-oriented asset to their portfolio as well as gain exposure to global economic growth potential. He outlines why he thinks it’s an opportune time for many investors to consider diversifying into global real estate through an actively managed investment vehicle.

Wilson Magee

Wilson Magee
Director of Global Real Estate and Infrastructure Securities

Franklin Real Asset Advisors®
Portfolio Manager, Franklin Global Real Estate Fund, Franklin Real Estate Securities Fund

Diversifying into REITs in a Rising US Interest-Rate Environment

Given expectations for a rising interest-rate environment in the United States in 2015, and what is likely to be another volatile year for global equities, we think many investors should consider holding a broad and diversified portfolio. While it’s true that rising US Treasury rates can make yield-sensitive investments like real estate investment trusts (REITs) appear to be less appealing on the surface, we counter with evidence that adding REIT exposure has its merits—even in a rising-rate environment.

What Are REITs?

A REIT is a type of publicly traded company that invests directly in real estate and related assets. Many REITs specialize in a specific type of property, such as shopping centers, warehouses, apartments, hotels, office buildings or self-storage units. Many also concentrate in a specific geographic zone, such as the United States, Japan, the United Kingdom or other nations. In most countries that have REITs, companies that qualify generally are exempt from normal corporate taxes. In markets where REITs or REIT-like structures do not exist, other publicly traded real estate companies are often available for investment.

REITs primarily offer several potential benefits: diversification from traditional stocks and bonds, income opportunity, and exposure to the real estate sector.

Diversification: REITs have historically had reduced correlations with traditional asset classes such as stocks and bonds.1 While past performance is no guarantee of future results, if historical correlations2 to bond returns continue, we think REITs can provide an important element of diversification. (Diversification does not guarantee profit or protect against risk of loss.)

Income Opportunity: To preserve their special tax status, generally REITs must distribute income back to shareholders in the form of dividends. US REITs, for example, are required to distribute 90% of taxable income to shareholders.3 We think these dividend distribution requirements make REITs an opportunity to consider for investors in search of potential income.

Sector Exposure: Publicly traded REITs offer investors a more liquid way to invest in the real estate sector, compared to purchasing real property directly. Direct real estate investing is generally more illiquid, carries higher transaction costs, necessitates a more active role on the part of the individual investor, and often requires a higher minimum investment. Global REITs investing outside of the United States can offer additional diversification potential by allowing investors to gain exposure to worldwide real estate markets. Direct investment in overseas real estate, by contrast, generally carries much higher barriers to entry. Investing directly in property internationally can involve additional legal and tax complications as well.

Many real estate operating companies are also listed and traded on exchanges, just like REITs. However, they typically are subject to local corporate taxation and aren’t required to distribute cash flow back to investors.

US Interest Rates Likely to Rise

US interest rates remain near historic lows but are likely to rise as the economy begins to feel the impact of the conclusion of the Federal Reserve’s six-year quantitative easing program.

Federal Reserve (Fed) Chair Janet Yellen has remarked that the Fed will eventually tighten the monetary supply by raising short-term interest rates rather than selling off bonds. This is a strong indication to most market watchers that higher US interest rates loom in the near future—although the exact timing and pace of Fed tightening are still subject to speculation.

US REITs (as represented by the FTSE NAREIT Equity REITs TR Index) have historically performed well in periods of rising interest rates.4 Between 1994 and 2013, the United States experienced nine distinct time periods when interest rates rose (as measured by the 10-year US Treasury note yield) by greater than 100 basis points (1%). During six of these nine time periods, REITs provided positive returns, while in three, REITs provided negative returns, as illustrated in the chart below.

US REITs and stocks snip2

In our view, rising interest rates that reflect a healthy, growing economy (as opposed to sudden or extreme interest-rate hikes) could be positive for both US stocks and REITs. Both could also benefit as employment, consumer spending, and real estate demand rise. Real estate, in fact, can be—and has been—viewed by many investors as a good barometer of overall economic health.

Exposure to REITs, we believe, can help investors potentially capitalize on an improving economy while still maintaining diversification from traditional assets such as stocks and particularly, bonds as a broad asset class.

Global Exposure

In our view, investing in US REITs has merit in a rising-rate environment, but we also believe in the merits of maintaining a diversified portfolio in general, which we view as requiring exposure to the global economy, including worldwide real estate.

We believe global markets are poised for long-term growth, despite some near-term challenges in select markets. Gross domestic product growth in a number of emerging markets has been robust, particularly in parts of Asia, but global stocks were volatile in 2014, due in part to worries about the health of the European economy as well as geopolitical tensions in the Middle East and Ukraine/Russia.

In fact, global REITs have outperformed global stocks (as represented by the MSCI World GR USD Index) in the previous 5-year and 10-year periods.5

Allocation case

Fortunately, as REITs have exploded in popularity since the 1990s, many other nations have enacted legislation to establish REIT structures. The United Kingdom, Singapore, Australia, Canada, France, Finland, Hong Kong, Japan, the Netherlands, New Zealand and South Africa, among others, allow investors from around the world to gain exposure to their growing property markets through REITs.

Potential Alternative Income Opportunity

Many investors look to their bond allocation to provide their portfolios with a strong potential income component, as well as diversification from stocks. But bond yields remained low in the past year in the developed world, and many people expect them to stay that way for some time. Even if the Fed starts raising interest rates this year, we believe it will most likely do so gradually.

REITs can provide income opportunities as well as the potential for long-term capital appreciation. REITs are generally considered yield-oriented investments, and a component of their returns comes from dividends rather than price gains.

Like all yield-oriented investments, REITs will likely exhibit some

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