By Scott Craig
There is a major debate about how much and how soon the Federal Reserve will increase short-term interest rates. I am inclined to think that conflicting economic data (weak commodity prices, weak PMIs, slowing housing, high inventories) are more likely than not to lead to a series of small, gradual rate increases.
But it is important to take any such prediction (including mine) with a considerable grain of salt, and to avoid making significant investment decisions based on a misplaced level of confidence in any interest-rate prediction. I think it is far better to allow long-term goals and risk tolerance to influence portfolio decisions.
Given that view, and in this continued low rate environment, investors remain hungry for yield. However, many investors fail to consider established investment options outside of bonds or dividend-paying equities like utilities. We have three reasons why investors should consider an allocation to REITs in their portfolios:
1. Dividends or current income. REITs are required to pay out at least 90% of taxable income. As such, the yield on REITs has historically been considerably higher than other equities.
2. Diversification. REITS are a distinct asset class, different from bonds and equities. REITs help investors gain direct exposure to traditionally illiquid real estate markets (office, industrial, retail, residential, hotels, etc.) and on a wide geographic basis.
3. Inflation hedge. In a rising price environment, rents and property prices have historically climbed. This type of inflation hedge may protect investors. In fact, REIT dividend hikes have increased more than the CPI in all but two of the past 20 years.
Regarding the first point, we note that the dividend yield in the REIT space (as measured by the FTSE NAREIT All Equity REITs dividend yield) has consistently outpaced inflation, the general equity market dividend yield (as measured by the S&P 500) and, importantly, the fixed-income market yield (as measured by the yield to maturity of the Barclays US Aggregate Bond Index). While we do believe interest rates will begin to rise at some point, we think this demonstrates the potential advantage of having an allocation to REITs in any interest-rate environment.
Second, we have seen correlations between asset groups increase over the past two decades, resulting in fewer diversification benefits. REITs, on the other hand, have maintained a distinct and lower correlation to several other important asset classes. Using a variety of indexes as proxies (including the S&P 500, Russell 1000 Value, MSCI Emerging Markets, Bloomberg Commodities), the REIT group has maintained a correlation below 0.6 compared to each of these indexes, effectively demonstrating why it may be a great diversifier in a portfolio.
I also believe REITs have another important feature to consider. With more than 200 US REITs to choose from and an industry market cap of more than $900bn, investors not only have choices (such as property type and geographic market), but also the potential to more easily get in and get out as needed. Many investors might prefer a diversified mutual fund over picking individual REIT stocks, as that approach provides similar liquidity benefits without the burden of stock picking.
To sum up my views, I think it can be beneficial to zig when the rest of the market zags. REITs can be an important source of income and diversification, and they may also help hedge against inflation. With the potential for rising long-term rates and concerns about inflation, we think that REITs could defy market expectations and outperform the broad market. And if a low-yield world persists for longer than many expect, we suggest looking at the often overlooked REIT group for a potential source of consistent, reliable and growing income.
Scott Craig is a portfolio manager at Eaton Vance
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