NEW YORK — The threat of rising interest rates is raising fears about real estate mutual funds. Investors have pulled money out of real estate funds for two straight months, even though they remain among the year’s best performers and pay bigger dividends than many stock funds. The worry is that rising rates will hurt growth for the owners of apartment buildings, offices and other commercial real estate, as well as limit demand for their stocks.
Before joining the crowd, bear in mind that rising rates don’t always mean losses for real estate funds. Many have delivered solid returns even during periods of rising interest rates. The key is how quickly and how high rates rise. Real estate fund managers say they can still make money for investors, though they acknowledge that the performance won’t be as good as this year and the recent past.
“One of the things you have to ask is why are rates rising,” says John Wenker, co-portfolio manager of Nuveen’s Real Estate Securities fund since 1999. “If rates are moving up moderately because the economy is starting to strengthen, that’s fine for commercial real estate.”
For real estate funds, dividends are king. Most invest in real estate investment trusts, which can avoid income taxes if they pass on 90 percent of their profit to shareholders as dividends. REITs can own shopping centers, self-storage units or senior housing communities.
Because they pay so much income as dividends, REITs attracted investors tired of low bond yields. That demand helped the average real estate fund return an annualized 17.4 percent over the last five years, according to Morningstar. That beats the 15.6 percent annualized return for the Standard & Poor’s 500 index over the same time.
One concern for REITs is that a rise in interest rates, which economists say is inevitable, will push investors back to bonds. Higher interest rates also make it more expensive for REITs to raise money to buy and develop real estate.
Those fears hurt REITs last year, when the Federal Reserve hinted that it may curtail its bond-buying stimulus program. The yield on the 10-year Treasury note quickly jumped from 1.63 percent in early May to nearly 3 percent by the end of the year. That drove the average real estate fund into the red in the last three quarters of 2013. For the year, the average real estate fund returned just 1.5 percent, versus 32.4 percent for the S&P 500.
REITs can deliver gains if the increase in rates is more moderate and the result of an improving economy. In such a scenario, fund managers say property owners should be able to charge higher rents and have fewer vacancies for their apartments and office buildings. That would lead to higher dividends.
