REIT Investors are Trapped by Interest Rate Risk

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REIT (real estate investment trust) investors seeking fixed-income should be worried by interest rate risk. Currently, they are chasing yields by bidding up higher-risk securities. Instead, they should consider the idea that we are in a fixed-income bubble, and should avoid paying too much for yields.

REITs have seen their price multiples ascend beyond reason:

<table> <tbody> <tr> <td> <p><strong>Ticker</strong></p> </td> <td> <p><strong>Company</strong></p> </td> <td> <p><strong>P/E</strong></p> </td> <td> <p><strong>P/B</strong></p> </td> <td> <p><strong>Div Yield</strong></p> </td> <td> <p><strong>Payout Ratio</strong></p> </td> </tr> <tr> <td> <p>(<a href="">HCP</a>)</p> </td> <td> <p>HCP</p> </td> <td> <p>29.94</p> </td> <td> <p>2.04</p> </td> <td> <p>4.4%</p> </td> <td> <p>1.32</p> </td> </tr> <tr> <td> <p>(<a href="">SPG</a>)</p> </td> <td> <p>Simon Property Group</p> </td> <td> <p>31.47</p> </td> <td> <p>8.35</p> </td> <td> <p>2.8%</p> </td> <td> <p>0.81</p> </td> </tr> <tr> <td> <p>(<a href="">PSA</a>)</p> </td> <td> <p>Public Storage</p> </td> <td> <p>39.57</p> </td> <td> <p>2.9</p> </td> <td> <p>3.1%</p> </td> <td> <p>1.19</p> </td> </tr> <tr> <td> <p>(<a href="">AMT</a>)</p> </td> <td> <p>American Tower</p> </td> <td> <p>43.05</p> </td> <td> <p>8.47</p> </td> <td> <p>1.3%</p> </td> <td> <p>0.56</p> </td> </tr> <tr> <td> <p>(<a href="">VNO</a>)</p> </td> <td> <p>Vornado Realty Trust</p> </td> <td> <p>45.17</p> </td> <td> <p>2.07</p> </td> <td> <p>3.6%</p> </td> <td> <p>1.62</p> </td> </tr> <tr> <td> <p>(<a href="">VTR</a>)</p> </td> <td> <p>Ventas</p> </td> <td> <p>47.50</p> </td> <td> <p>2.03</p> </td> <td> <p>3.8%</p> </td> <td> <p>1.78</p> </td> </tr> <tr> <td> <p>(<a href="">AVB</a>)</p> </td> <td> <p>Avalonbay Communities</p> </td> <td> <p>51.33</p> </td> <td> <p>2.77</p> </td> <td> <p>2.9%</p> </td> <td> <p>1.43</p> </td> </tr> <tr> <td> <p>(<a href="">BXP</a>)</p> </td> <td> <p>Boston Properties</p> </td> <td> <p>53.20</p> </td> <td> <p>3.07</p> </td> <td> <p>2.5%</p> </td> <td> <p>0.61</p> </td> </tr> <tr> <td> <p>(<a href="">EQR</a>)</p> </td> <td> <p>Equity Residential</p> </td> <td> <p>89.31</p> </td> <td> <p>2.8</p> </td> <td> <p>2.4%</p> </td> <td> <p>1.81</p> </td> </tr> <tr> <td> <p>(<a href="">HCN</a>)</p> </td> <td> <p>Health Care REIT</p> </td> <td> <p>116.73</p> </td> <td> <p>1.49</p> </td> <td> <p>5.0%</p> </td> <td> <p>5.76</p> </td> </tr> <tr> <td> <p>(<a href="">PLD</a>)</p> </td> <td> <p>Prologis</p> </td> <td> <p>352.70</p> </td> <td> <p>1.21</p> </td> <td> <p>3.2%</p> </td> <td> <p>10.15</p> </td> </tr> <tr> <td> <p>(<a href="">HST</a>)</p> </td> <td> <p>Host Hotels & Resorts</p> </td> <td> <p>761.50</p> </td> <td> <p>1.6</p> </td> <td> <p>2.4%</p> </td> <td> <p>14.41</p> </td> </tr> <tr> <td> <p>(<a href="">GGP</a>)</p> </td> <td> <p>General Growth Properties</p> </td> <td> <p>NA</p> </td> <td> <p>2.47</p> </td> <td> <p>2.2%</p> </td> <td> <p>0.00</p> </td> </tr> </tbody> </table>

These price-to-earnings multiples are appropriate for tech companies with new products that are poised for growth, but not for real estate. Worse yet, many of these REITs have unsustainable dividend payouts that exceed their earnings.

There are many other signs of a bubble in fixed-income.

Corporations Rushing to Issue Bonds

The five-week period ended Nov. 14 saw dealers that trade with the Federal Reserve increase debt holdings by $13 billion to around $58 billion, a record volume of debt sales, as the biggest banks seek to boost their corporate-bond stockpiles. These have been the most rapid sales since 2007.

Investors are starved for yields, leading them to move to higher-risk securities. In search of bigger yields, demand for corporate bonds has risen, and the spread between government and high-grade corporate bonds has narrowed, signifying investor confidence. Stimulus plans by the Federal Reserve also have a hand in this, since it has pushed investors into riskier assets such as investment-grade and even high-yield bonds. The plans by Fed Chairman Ben Bernanke of buying bonds as well as saying that the Fed is anticipating interest rates at around zero until at least mid-2015 has seen a spur of about $1 trillion in bonds traded so far in 2012.

Among the biggest holders are dealers Goldman Sachs (NYSE: GS) and JPMorgan (NYSE: JPM), who increased their inventories by 29% since Oct. 10, their highest level of corporate bonds since September 2011 when holdings hit around $60 billion. Amazon also tapped the bond market for the first time in over a decade to sell $3 billion worth of debt.

Royal Bank of Scotland (NYSE: RBS) and Wells Fargo (NYSE: WFC) are also reportedly marketing around $1 billion of bonds linked to commercial-property loans, among them hotels, shopping malls, and office buildings. Tribune is also reported to be seeking about $1 billion of loans to back its exit from bankruptcy, an arrangement syndicated by CitigroupCredit SuisseBank of AmericaDeutsche Bank, and JPMorgan. In overview, about $35 billion in commercial- mortgage backed securities offerings have been arranged by Wall Street this year, compared to last year's $28 billion. Despite banks creating record levels of new corporate bonds in recent months, they have also reduced their holdings to just 25% of the $235 billion accumulated in October 2007 due to the stringent Volcker Rule, which seeked to limit risks after the financial crisis.

While explaining the developments, an overseer of investment-grade credit at Columbia Management Investment Advisers, Thomas Murphy, asserted, "When the market has a really good tone and it's feeling more liquid the Street is probably more inclined to take down inventory with the expectation that they'll be able to mark it up and sell it. That can unfortunately backfire for them if the music stops and you get some spread volatility like we've gotten."

Swelling Fixed-Income Funds

Investors are allocating a larger portion of their portfolios to fixed-income funds. Before the financial crisis, equity-focused mutual funds and exchange-traded funds had the most assets under management. Today, the fund with the most assets under management is the PIMCO Total Return fund, which has about 65% of its assets allocated to fixed income. Its $244 billion in assets under management exceeds the Vanguard Total Stock Market Index, which has $16 billion in assets.

Record Low Rates

Investors can also check historical interest rates published by the Federal Reserve, which show that yields over the past two years for the 10-year treasury are the lowest since they have been keeping track.


The high valuations of REITs can only be justified if they are growth stocks or if their dividend yields exceed low interest rates indefinitely. Neither assumption is reasonable. REITs are ultimately boring real estate businesses, and do not have the earnings growth potential of tech firms. Also, many of these REITs are paying unsustainable dividends, and will have to curb their payouts. Finally, market interest rates could rise closer to historical levels, which would again challenge the value of these securities.

BillEdson11 has no positions in the stocks mentioned above. The Motley Fool owns shares of JPMorgan Chase & Co. and Wells Fargo & Company. Motley Fool newsletter services recommend Goldman Sachs Group and Wells Fargo & Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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