Rising interest rates may not be wrong for REITs after all

new york» Real estate investment trusts have been on a tremendous run since the financial crisis. Their returns have surpassed the broader market since early 2009, in part because the relatively big dividends they pay looked increasingly attractive as interest rates fell year after year. Now, though, the economy has gained momentum, and the Federal Reserve looks ready to raise interest rates this year from their record low.

Conventional wisdom says rising rates will mean pain for real estate investment trusts, or REITs, which own apartment buildings and shopping malls and pay out at least 90 percent of their profit as dividends. Not only would rising rates push investors to dump REITs and other dividend-paying stocks to go back to bonds, they would also raise expenses for REITs.

That conventional wisdom is a misconception, fund managers say. As long as the economy is improving, REITs can charge higher rents for their hotels, self-storage units and other properties and increase their profits and dividends. That should help them offset the effect of rising rates, and that’s what happened in 2004-06, when the Federal Reserve was last raising rates.

But the managers also understand that the conventional wisdom is deeply ingrained and that some investors will reflexively sell REITs when rates are heading higher. The question is whether the selling will be enough to cause a sharp drop in prices, at least for the short term.

“There is an element of groupthink out there,” says Mark McAllister, co-manager of the ClearBridge Tactical Dividend Income fund. “People think, ‘The Fed is raising rates; it’s time to head for the hills.’ ”

Earlier this year, it looked like a big downturn may be on the way. A strengthening job market was raising optimism that the economy was hitting a higher gear and expectations that the Federal Reserve would raise rates.

That sent equity REITs on a six-week losing streak, their longest in nearly five years. Investors pulled nearly $1 billion from one exchangetraded fund that tracks REITs in February alone.

But the momentum shifted in mid-March, after the Federal Reserve indicated it may raise rates at a slower pace than many had been expecting. REITs rebounded and had their best week in more than three years, although they have since given back some of the gains.

“They’ve gotten a reprieve,” says Tom Kolefas, manager of the TIAA-CREF Mid-Cap Value fund. He owns a mix of REITs in his fund, but less than the index he uses as a benchmark. “People are saying, ‘OK, rates aren’t rising tomorrow, and you know it’s not so bad.”

“I don’t expect there to be a panic,” says Jason Yablon, global portfolio manager at Cohen & Steers, which specializes in real estate securities.