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Looming Rate Rise Weighs on REIT Shares

12/01/2015 | 11:43am US/Eastern
By Liam Pleven 

For months, investors and executives have been waiting for shares of real-estate investment trusts to catch up to the broader stock market and reflect the value of the properties the companies own.

They may have to wait at least a little while longer.

The MSCI US REIT Index ended November down 1% while the S&P 500 finished the month basically flat. Despite a rally in many REIT stocks since September, the REIT index has fallen 2.7% year to date, while the S&P is up 1% through Monday.

REITs are trading at a nearly 12% discount to their net asset value, according to real-estate research firm Green Street Advisors, as investors worry that real-estate values could take a hit if the Federal Reserve raises interest rates or the economy turns out to be weaker than it seems. In September, that discount--which reflects the gap between what the companies are worth in the stock market and the estimated value of their real estate--was larger than at any point since 2009, according to the firm.

More pain could be imminent if the Fed decides this month to raise short-term interest rates, as is widely expected.

The prospect of higher rates has been widely blamed for the underperformance of REIT stocks this year. The REIT index closed at its low for the year in early September amid a debate over whether the Fed would act that month, which it ultimately decided not to do.

Higher interest rates can threaten REIT shares by making the steady dividends the companies often pay shareholders look less attractive relative to the safety of bonds. When investors sour on REIT stocks, it also makes it harder for the companies to raise money by selling shares to purchase additional property and grow.

"Clearly the markets are signaling some concern about a rate rise," said Michael Torres, chief executive officer of Adelante Capital Management LLC in Oakland, Calif., which owns shares in many large REITs.

While the impact already is reflected in prices to some degree, there may be a short-term reaction when the rate rise actually occurs. That contributes to the uncertainty over the outlook for REIT share prices for the remainder of this year and into 2016.

REIT shareholders, however, have been counting on relatively sound fundamentals in the real-estate business to overcome those obstacles, including a decent economy, lower unemployment and steady demand from both individual and institutional tenants.

Sherry Rexroad, a managing director who oversees REIT investments at BlackRock Inc., the large asset manager, said she expects REITs will see earnings growth of about 8% in 2016.

As a result, she added, "You should see REIT prices continue to recover."

Conditions look particularly favorable for REITs that own multifamily apartment buildings, said Ms. Rexroad, because a healthier economy encourages people to form new households, but borrowing to buy a first home remains challenging after the financial crisis and with many young workers preferring to rent.

Two large apartment REITs, AvalonBay Communities Inc. and Equity Residential, are among the sector's strongest performers in 2015. Share prices of each company have risen 11% this year.

In addition, said Mr. Torres of Adelante, even if buyers sour on real estate and property prices fall, REIT investors have a "margin of safety" because the shares are generally trading at a discount to net asset value.

REITs should catch up to the broader market over the next six months or so, according to Gregg Fisher, founder of investment firm Gerstein Fisher, which runs the Gerstein Fisher Multi-Factor Global Real Estate Securities Fund, a REIT-focused mutual fund with nearly $100 million in assets. Real-estate stocks reflect the overall economy, so their returns should be similar to other stocks over time, he said.

But any move by the Fed is likely to have an impact in the short run, he said. So the timing of a REIT recovery "could be peculiar."

Write to Liam Pleven at liam.pleven@wsj.com

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