Originally published May 20, 2021
I don’t think there is anything inherently evil about Real Estate Investment Trusts (REITs). I have owned them in the past…they can be great depending on what you need them for. Generally, this asset class along with utilities, bonds, and some big stable low growth dividend companies attract those investors that want reliable low-risk incomes. The better question is are they really low risk?
The answer may be surprising because most investors think that no matter the situation they can count on those dividends or monthly REIT payments and all is well. The biggest problem is the underlying value of the asset can change depending on the interest rate situation. They tend to be interest rate sensitive! It’s nice that your income keeps coming in, but if you’re losing 20% on the stock every year, the payout/dividend is not going to make up for the loss, leaving you feeling a little on the poor side.
You may be wondering, how can all these different asset classes act the same way when they are all different businesses? Its Math! These assets provide a stable income with little underlying growth. It’s no different than a simple Bond, and Bond values vary with interest rates. So mechanically they must all act in a similar way. If your asset pays 2% annually and rates rise from 2% to 4%, then no one will want your asset when they can just buy a new one with a much higher rate. The only way to entice someone to buy your unwanted asset is to drop your price until it ends up paying a similar return as the higher rate. Mathematically, a move in interest rates from 2% to 4% would drop your asset value in half to make up for the higher rate that the new bond gets. This is a simplistic view of how this type of asset gets priced in a rising rate market as there are other factors involved such as risk, payout ratios, free cash flow, etc. Nevertheless, conceptually this is how it works. This phenomenon also affects regular stocks but at a much smaller magnitude. Stockholders are enticed to switch to bonds for higher returns, which lowers the demand for stocks and lower stock prices follow.
In our low-rate environment, one could argue that there is no other place rates can go but up. In fact, inflation has started to increase in the USA and that could lead to higher interest rates should the economy get overheated. At the same time, governments have messaged that they expect to keep rates low for a long period to kickstart and support the stalled economy. Raising interest rates would be bad for governments because they have piled a lot of covid debt on their books. The carrying costs (interest payments) of those debts are manageable only because of near-zero short-term rates. If inflation gets out of hand, they will increase rates to counter this and cause mayhem in the markets.
Should You Dump Your REITs, Bonds, AT&T, and Utilities?
The answer, like always, is “it depends”. Interest rates may not go up much and remain stable for years, but maybe not, no one knows for sure. Investing is a probability game, not a certainties game so I generally make my investment decisions where the likeliness of being right over time will be in my favour. My view is that given enough time it’s likely that rates will rise after decades of falling. This is why I do not own any of these right now. But what if I am wrong? A question you should always ask. The effect of being wrong would be limited because a well-balanced portfolio would only have a small weighting of these assets anyway, definitely less than 10%…. more likely around 5%. That being said, being wrong would not cause a substantial loss and my other assets could potentially make some of that up. If I am right, I will outperform a bit, and a bit is all I need.
Where is the hidden danger for the small investor?
Anyone who has loaded up on these assets or is practicing a traditional 60/40 split of stocks and bonds could see substantial volatility over time should rates increase. Should we panic? Only if you have too many. If you have a small amount as you should, there is no rush as rates increase slowly over time. You will see a slow deterioration of your asset values but you will still be collecting income to offset this. Eventually, most assets provide similar returns over the long term. The problem is that most investors lose patience and sell losing positions right when they are ready to turn around. They buy high and sell low.
Warning! Not all reits and utilities are the same. I have generalized the world in this newsletter and it’s never quite so simple, as there are many REITs that can have decent growth and are less sensitive to changes in interest rates. I prefer these types as they act more like conventional stock but have a smaller monthly payout or dividend compared to the traditional REIT.
Looking Forward
I continue to have difficulty in reading my crystal ball. The market sounds expensive if you listen to “experts” and of course, there are many warnings that come when you’re flying so high. I would say that there are some frothy areas in the market, but these are strange days and evaluations may stay like this for a very long time. Other than real-estate , like your house, there is no other game in town when it comes to longterm performance. So can the market crash? Of course, it eventually does, but no one knows when or how big. Trying to time an exit because the market appears expensive and therefore scary only lowers returns in the long run. You are likely going to be wrong getting out, and likely wrong getting back in, and in the end, only luck will determine if you have made the right choices. I do like luck but I would never bet on it and prefer to ride out the long term fully invested where I know that I will do fine.
Happy investing.
Marc’s Monthly Moves
Nada.
Marc’s Portfolio YTD Performance
- Portfolio return 3.9% (Including currency losses/gains)
- Portfolio return 8.6% (without currency losses/gains)
- SP 500 return 9.57
The portfolio underperformed the SP500 by -1.0 points.
Money with Marc 