Despite what many experts predicted earlier this year, interest rates have returned to near record lows. Instead of exceeding five percent, which was forecasted, rates are closer to 4.2 percent. As a result, current conditions are ripe for investors looking to increase their yield by the end of this year. In fact, current rates are projected to boost housing activity this fall, as real estate remains one of the best vehicles for maximizing investment returns. Perhaps even more importantly, investing in real estate investment trusts (REITs) has, yet again, outperformed the broader U.S. stock market. Investors have increasingly moved from stocks in search of the higher yield REITs.
According to the National Association of Real Estate Investment Trusts, listed U.S. equity real estate investment trusts were up 16.25 percent, with a dividend yield of 3.52 percent, in the first half of 2014. Conversely, the total return of the S&P 500 Index in the same period was 7.14 percent, with a dividend yield of just 2 percent. The numbers don’t lie. REITs continue to outperform the rest of the stock market and investors are catching on.
“The outperformance compared to the S&P 500 index came from REIT sectors representing a broad range of U.S. economic activity, and was supported by good supply and demand balance in commercial real estate markets around the country,” said NAREIT President and CEO Steven A. Wechsler.
Commercial real estate has seen its stock soar in recent months. In particular, multifamily apartment buildings, self-storage and regional malls seem to be leading the torrid pace of the current commercial real estate boom. Office units, on the other hand, have not shared in the same results. Employers continue to transition to the benefits offered by telecommunication, essentially foregoing the need to expand office space.
While several factors may be attributed to the recent commercial real estate boom, experts concur that low mortgage rates are the real drivers of REITs. Mortgage rates made available to borrowers make subsequent investments that much more attractive. Profit margins are simply too hard to ignore.
“That has really been a big tailwind for the group,” said Steve Sakwa of ISI Group. “Low interest rates are a positive for REITs because they really offer investors an attractive yield alternative relative to Treasurys or fixed income and you have a growth characteristic to that dividend yield that will go up and increase versus kind of a fixed return over a period of time.”
Sakwa has made it known that his expectations for commercial real estate are tempered, as a wealth of other analysts believe interests rates will rise and impede the profit margins on REIT returns.
“I think we are going to see a pullback,” said David Toti of Cantor Fitzgerald. “I think in the near term there’s some potential weakness, but our view at this level, real estate is fairly valued.”
Despite current trajectory of REITs, those familiar with the market exhibited some concern as recently as last year. Multifamily rental apartment buildings, in particular, were at risk of overwhelming potential demand. The housing recovery surged in 2013, and the expectation was that it would continue at the same rate this year. On the contrary, investors moved out and demand from mortgage-dependent owner-occupants didn’t pick up the slack.
Today’s market has seen rental demand increase, as housing costs remain too high for the average consumer. However, in that same time, rates have never been higher than they are now. Apartment REITs are up about 25 percent as a group year to date.
According to the most recent reports issued by Freddie Mac, demand has absorbed the current supply of multifamily units. Accordingly, market fundamentals are expected to remain strong for at least the next two years. During the recession, experts have estimated that 3.9 million households were created as a result of unaffordable conditions. Young adults accounted for nearly 75 percent of the pent-up households. In fact, the need for rental units is growing so fast that experts believe the market will need to add an additional 440,000 houses each year just to meet the demand. This is only encouraging news for REITs, and should promote them over the broader U.S. stock market.
“Over the long run, we expect the demand for multifamily units to be stronger than pre-recession levels. As the economy improves, and most pent-up demand releases, demographic trends will be (disproportionately) favorable for the multifamily sector, due to the young adults comprising a large share of suppressed household formation,” said Steve Guggenmos, Freddie Mac senior director of multifamily investments and research, in the report.
It has been some time since we had such a combination of strong real estate fundamentals, relatively disciplined supply, good demand and accommodative capital markets. From a fundamental perspective, commercial real estate and institutional quality commercial real estate are doing really well. Investors looking to increase their yield would be hard pressed to ignore the benefits of REITs over stocks.