What Happens to Real Estate When the Fed Raises Rates?

What Happens to Real Estate When the Fed Raises Rates?

What Happens to Real Estate When the Fed Raises Rates?

 The Federal Reserve seems likely to raise interest rates in December, barring a collapse in the economy. How will that affect real estate?

Despite its reluctance to raise the federal funds rate in September, the Federal Reserve seems likely to raise interest rates in December, barring a collapse in the economy. In the past, when interest rates have risen, real estate as a whole has tended to underperform, but that may not be the case this time around.

“U.S. real estate will probably trade off a bit [when the Fed raises rates], but Latin America will probably be relatively cushioned against any policy move,” said Jamie Anderson, managing principal of Tierra Funds.

Part of the reason the Federal Reserve, led by Janet Yellen, has been so reluctant to raise interest rates is the effect it would have on global markets, particularly in light of the economic volatility seen in Europe, following Brexit. “The Committee continues to closely monitor inflation indicators and global economic and financial developments,” the Federal Open Market Committee stated in its September 21 release.

 However, not all real estate is likely to be negatively affected, with Mexican REITs, for instance, already trading at a discount due to the weakness seen in the peso.
Latin America real estate over the past 60 days has gained 4% compared to the Real Estate Select Sector SPDR Fund State Street Global ETF (XLRE) , a huge spread that is rarely seen. As such, Anderson has been recommending the Tierra Funds Latin American Real Estate ETF (LARE) to his clients, thinking it can go up between 10% and 15% plus the yield over the next twelve months. Anderson helped create the fund as part of his role at Tierra Funds.

Looking further out, Anderson thinks U.S. real estate, in particular real estate investment trusts, will have more time to adapt and adjust, since the Fed is likely going to take a longer time frame to adjust to normal policy — in this case two to three years — easing the pressure on real estate. “The risk for U.S. REITs is investors may not get the appreciation they’ve seen over the past one to two years — dividend growth will be there and you can get a decent coupon, but there may not be a lot of upside,” Anderson said.

Real estate finally has its own sector in the S&P 500, which gives the $2 trillion asset class a clearer and more transparent way to benchmark. It’s not a one-size fits-all category, and some parts are likely to be less sensitive to a rate hike, chief among them, multi-family real estate.

“Multi-family real estate is going to be a little less reactive to interest rate changes because it’ll provide a better bump in rents as the economy gets better,” Anderson explained. The Vanguard REIT ETF (VNQ) holds residential REITs in its portfolio as well as commercial and specialized REITs. VNQ may also continue to outperform because of its exposure to the industrial economy, which because of the nature of the business, is more closely tied to the global economy and can surpass some of the interest rate-tied headwinds seen in other portions of real estate.

Conversely, areas that are more sensitive to interest rate rises, such as malls, are likely to underperform, Anderson explained, because of “an increase in the cost of capital which will be another headwind for an already struggling sector.”

Other areas around the globe, including the Middle East and specifically Turkey, are quite interesting to Anderson because of young demographics. “Any country that has favorable medium or long term demographics is going to be very good for real estate,” Anderson said.

Benzinga – Sep 2016

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The S&P Dow Jones Indices and MSCI will give real estate its own unique class, separating it from the gang within the financials sector. The parting of ways comes as real estate as a sector has outperformed the S&P 500 with S&P’s REIT industry index up 24 percent annually since the bull market began in 2009, versus 18 percent for the benchmark.

The new classification will include all real estate investment trusts (REITs) with the exception of mortgage REITs, which will remain classified under financials.


Man reviewing financial affairs using investment statement

Rafe Swan | Getty Images
Man reviewing financial affairs using investment statement

Being a standalone category is a double-edged sword. The new classification will attract passive investors looking to track a new major sector of the market and may bring in new money from active investors who may not have been aware of the sector’s strong performance. But memories of the real estate crash and the mortgage crisis in 2008 may be enough to deter some investors, rightly or wrongly, who still see real estate as risky.

“Reclassifying REITs and real estate operating companies (REOCs) into a standalone sector, apart from providing a more accurate description of the companies themselves, will likely raise the profile of real estate fundamentals overall,” said Jamie Anderson, managing partner of Tierra Funds, which offers the Tierra XP Latin America Real Estate ETF.

REITs have outperformed the broader markets because they are a strong dividend play in a low-yield environment. REITs are required to pay at least 90 percent taxable income annually in the form of shareholder dividends; real estate stocks today provide 7 percent earnings growth and 3-plus percent dividend yield. In addition, the fundamentals of the commercial real estate market, especially the industrial, apartment and office sectors, have seen a strong recovery since the recession. Their classification under financials may not have highlighted that strength.

Technically, what is happening is that real estate will be its own category in something called the Global Industry Classification Standard structure, a guidepost of sorts for the global financial community. This marks the first time a new sector has been created under the GICS structure since it began in 1999.

“This is the first significant structural change to GICS sectors since its inception and reflects the position of real estate as a distinct asset class and a foundational building block of a modern portfolio, rather than an alternative,” said Remy Briand, managing director and global head of research at MSCI. “GICS was developed as a means of standardization that would keep up with the evolving investment landscape.”

The change was first announced last spring. “The creation of an eleventh sector recognizes the growing importance of real estate in the world’s equity markets,” said David Blitzer, managing director and chairman of the index committee at S&P Dow Jones Indices, in the announcement at the time. “The decision to add a real estate sector was based on extensive comments from investors and analysts as well as in-depth analysis and discussions between S&P Dow Jones Indices and MSCI.”

Of course, any change of this magnitude creates anxiety. “Unanticipated consequences are that people that are looking at the current financial index [are seeing] those returns have been enhanced by real estate,” noted Alexander Goldfarb, managing director and senior REIT analyst at Sandler O’Neill. “REITs will come out of financials, so the performance of the financial index can lose what had been a strong tailwind.”

Benzinga – Aug 2016

Meet This Year’s Best Real Estate ETF

Meet This Year's Best Real Estate ETF

The Federal Reserve’s refusal to raise interest rates to this point in 2016 coupled with investors’ seemingly unquenchable thirst for higher-yielding assets have created a perfect storm for real estate stocks and the corresponding exchange traded funds.

Additionally, real estate stocks and ETFs are getting increased attention ahead of the move, happening at the end of this month, that will see the group depart the financial services sector and become the 11th GICS sector. Obviously, those factors are benefiting US-focused real estate ETFs, but this year’s best-performing real estate is an emerging markets fund.

That honor goes to the Tierra XP Latin America Real Estate ETF LARE 0.33%, which as of August 9, is up 36.6 percent year-to-date. Said another way, LARE has posted better than double the returns offered by the largest U.S. real estate investment trust ETF.

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LARE debuted in December and tracks the Solactive Latin America Real Estate Index.

“The Solactive Latin America Real Estate Index screens for all listed equities with primary listings in the Latin America region and which derive substantially most of their income from real estate and real estate services. The Index then uses dividend yield, market capitalization and liquidity in the underlying shares to determine weights. The Index is rebalanced quarterly,” according to Tierra Funds.

With Brazil being one of this year’s best-performing markets, emerging or otherwise, LARE may garner comparisons to traditional Brazil ETFs. However, such comparisons are inaccurate. Brazil and Mexico, Latin America’s two largest economies, combine for 96 percent of LARE’s weight, meaning the ETF is more a dual country/regional fund than a single-country ETF.

Said another way, with Brazilian stocks hot, LARE is not going to outperform a traditional large-cap Brazil ETF. Simple math confirms as much, but that doesn’t diminish LARE’s opportunity set. Certainly not at a time when yield is a primary concern for many investors.

For those that insist on labeling LARE as a Brazil ETF, notable are the facts that as of August 9, LARE is showing volatility that is about half that of the largest Brazil ETF and a dividend yield that is more than 340 basis points higher. Speaking of yield, LARE’s dividend yield is 5.58 percent, which is far superior to what investors will find on standard U.S. REIT ETFs.

Likewise, combining the dividend yields on the larges Brazil, Mexico and Latin America regional ETFs generates a number that is below LARE’s yield.

Year-to-date, LARE has outperformed all other LatAm ETF strategies with the exception of the benchmark Brazil ETF and the lone Peru ETF.