Doubling Down on Speculative REITs in 2015

Last month, we looked at real estate investment trusts, or REITs for short. They’re a way to invest in real estate with little money down, and earn a solid cash return via dividends without having to deal with the hassle of being a landlord.

Along the way, you also get diversification by investing in a basket of properties. You also have liquidity. REITs trade like stocks, meaning that you can be in and out with a few clicks of the mouse or a phone call to your broker. You don’t need to manage & list properties, and you don’t have to pay fees to real estate agents that could turn a slight gain into a loss.

The downside is that you can’t use leverage the same way that you might by buying a property for 20 percent down and getting a mortgage on the outstanding balance. You’ll get to choose which REITs you invest in, but you won’t have direct control over what management chooses to buy, or how much the rents go up every year.

Of course, with any real estate investment, there’s one big danger that continues to lurk on the horizon… the prospect of higher interest rates …

The Interest Rate See-Saw

Interest rates are simply the price it costs someone to borrow money. Over the past few years, interest rates have been at or near historic lows. That’s made it less expensive to finance a car or obtain a home. Rising rates mean that the same monthly payments and the same cash amount just won’t buy you as much.

Say you’re able to comfortable pay $1,500 a month on a 30-year mortgage. At 4 percent interest, that $1,500 payment will allow you to have a mortgage of $250,000.

But at, say, 7 percent interest, that $1,500 payment would only cover a mortgage of $210,000. That’s 16 percent less home.

Asset prices and interest rates tend to act like a see-saw. When one is rising, typically the other is falling. When the cost to borrow rises, people won’t buy as many assets (at least not with borrowed money). Prices won’t rise as fast. And some people may even sell assets to keep money in the bank, safely earning interest. That’s often how prices will end up falling.

That’s a critical factor in any investment environment, but particularly so in real estate, where trillions of dollars have been lent against the value of a property. That’s not just true of individual properties, but REITs as well. After all, they use borrowed money to finance their acquisitions and operations.

Housing Follows the Fed in 2015

In the United States, interest rates are set on the free market with the buying and selling of US Treasurys.

But on the short-end of the yield curve, the Federal Reserve sets the rate that banks use to lend to each other overnight. A move from the Fed to raise or lower this rate tends to influence the overall market the same way a stone creates ripples when you throw it in a pond.

Back in 2013—after years of interest rates at or near zero percent—the Federal Reserve outlined a plan to start hiking interest rates in 2015. This news sent REITs into a sharp nosedive. But they’ve since recovered. After all, even if rates do go up a point or two, they’re still near all-time lows.

So as we enter 2015, the Fed finds itself in a bind. Other countries have aggressively started cutting interest rates this year. That’s caused the US dollar to strengthen relative to other currencies.

What are the implications?

It means that US companies with operations overseas are losing money when converting that revenue back into now more-expensive US dollars. That means the US economy could weaken. Areas cutting rates, such as Japan and the European Union, are set to get an economic boost since their currencies are now relatively weaker… and thus more competitive.

That ultimately means that the Fed’s in no rush to raise interest rates, which means that REIT investors will likely have to adjust their own expectations upwards—perhaps substantially. Even if the Fed does raise rates, they’re likely to do so very slowly.

Swinging for the Fences with these Speculative REITs

We’ve already looked at some of the best-of-breed players in the REIT space. But with the latest developments, a few speculative plays come to mind that may fare well in 2015.

The first is Prologis (PLD). It’s a REIT that focuses on the industrial space. Although headquartered in San Francisco, their operations are worldwide, with a heavy exposure in Europe and Asia. Industrial space has been in poor demand, with slowing economic growth in China, and the European Union showing nearly no growth in industrial output or demand.

Yet in spite of that challenge, Prologis has thrived. The company has a fat, 39 percent profit margin. They’ve got $9 billion in debt, but against $22 billion in equity, they have a healthy amount relative to other REITs. Revenue and earnings have been growing, in spite of a tough year for industrial space around the globe.

The only disappointment is the yield—it’s 3.0 percent, and many REIT players pay 4-5 percent yields instead. But if industry grows in 2015, then industrial space could come back in demand, fueling capital gains in the stock and higher earnings to justify a higher dividend payout.

Another speculation worth looking at is the largest triple-net commercial REIT, American Realty Capital Partners (ARCP). All the company does is acquire and rent out commercial space. Tenants are responsible for taxes, insurance, and maintenance—hence the term triple net.

Last year, the company announced some aggressive accounting that overstated their net income by 5 cents per share. As a result of the fear, shares fell as much as 40 percent in a matter of days. The board of directors has fired senior management, cut ties with the prior CEO who still served on the board and may have been involved.

The company currently has two accounting firms thoroughly checking the books for further accounting problems. Because of the fear of more problems emerging, the company trades at a steep discount to its peers in terms of book value and net operating income. The company is currently trading for far less than the value of all the properties it owns. That’s the opportunity, although it’s a risky one.

The results of the accounting review should be done by early March—so if you’re interested in a speculation based on a small accounting fraction, there seems to be huge upside in this REIT.

The Bottom Line:

In any event, the broad macroeconomic picture is still solid for REITs.

If you’re feeling speculative, there are some attractive options out there. If you’re just looking for a safe place to invest in real estate, the best-of-breed companies should continue to fare well this year as well.

Based in Miami, FL, Houses.com provides the world's largest online marketplace for homes and real estate. Showcasing over 4 million listings for sale, rent & vacation in over 70 countries,