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STOCK TALK: Rising Rates Triggers REITs Retreat
By Frederic Ruffy, Optionetics.com
4/12/2004 2:30:00 PM

http://www.optionetics.com/articles/article_full.asp?idNo=10218

The Dow Jones Real Estate Investment Trust [REIT] Index ($DJR) plunged last week and the slide continued on Monday. Since April 1, the index has now lost nearly 16%. Volatility in the sector has skyrocketed amid concerns that recent signs of economic strength might lead to higher interest rates, which could potentially drive investors out of real estate investment trusts. As a result, during the past six trading sessions, there has been a mass exodus from the REITs sector. The decline has in turn left many investors wondering: has the dramatic sell-off created a buying opportunity among Real Estate Investment Trusts, or is the decline in the sector a warning sign for other sectors of the US stock market?

Real Estate Investment Trusts are investment vehicles with shares listed for trading on the US stock exchanges. Also known as REITs, these trusts invest in different types of real estate properties. While some of real estate investment trusts deal primary with mortgages, others focus on commercial properties such as shopping malls and office buildings. There are also REITs that focus on residential properties. Investors buy REIT shares when they expect real estate prices to remain strong. However, when investors expect the real estate market to face tough times, they are more inclined to sell REITs.

Trading under the symbol DJR, the Dow Jones REIT Index is a market value weighted index consisting of more than one hundred different Real Estate Investment Trusts. The 114 companies within the Dow Jones Index represent 95% of the total REIT universe. Therefore, the performance of the index reflects the composite performance of most of the REIT investment vehicles that exist today.

During the month of April, the DJ REIT Index has been extremely volatile. The index hit an all-time high on April 1. From that point forward, it made a turn for the worse. On April 5, the index tumbled 4.1%. The next day, it slipped another 3.8%. It was the largest back-to-back decline in the index since its inception more than ten years ago. For the week, DJR fell more than 8%. Furthermore, on Monday, the slide continued, as the index plummeted another 5%. The chart blow shows the index’s freefall.

Some market watchers worry that a bubble in the real estate market had developed—one similar to the conditions that existed in the stock market prior to March 2000. During the past few years, low interest rates have led many investors to buy into REITs. As a result, since 1999, real estate investment trusts rose 63%, according to statistics from an article in Monday’s Wall Street Journal (“Booming Sector Starts To Show Stress Cracks,” by ES Browning). Since that time, the Dow Jones Industrial Average ($INDU) actually fell 9%. According to the article,

As most stocks sagged during the bear market, real estate surged. And as market interest rates—bond yields, money-market rates—fell to their lowest levels in 45 years, investors looked for other ways to generate steady dividend income. REITs on average have yielded about 7% historically. With real estate booming, they were the place to be.


Recently, however, some investors have been growing more concerned about the prospect of rising interest rates and the toll rising rates might have on REITs. For one, a monthly employment report released on April 2 showed a much larger-than-expected increase in jobs during the month of March. Meanwhile, a separate report released on April 5 showed stronger-than-anticipated strength in the non-manufacturing sector of the economy. The strong economic data in early April raised some talk among economists about the prospect of inflation. If so, the Federal Reserve may be forced into action, which would also mean moving interest rates up from 45-year lows.

It is the prospect of higher interest rates, then, that sparked the recent volatility in the REIT sector. If rates move higher, less risky investments, like Certificates of Deposit [CDs], money markets, or government bonds, may become more appealing vis-à-vis real estate investment trusts. In addition, some popular strategies designed to take advantage of low interest rates will no longer work if the Fed begins to raise rates. For instance, some financial institutions have been borrowing money at extremely low short-term rates, of 3% or less, and reinvesting that money in higher yielding investments like REITs. However, the specter of rising interest rates may have caused a knee-jerk reaction among some of these institutions last week. That is, the possibility of rising interest rates and falling REIT prices, triggered a wholesale sell-off in the sector that continued on Monday.

Some market watchers believe that investors may have overreacted and the decline in REIT prices represents a buying opportunity. Not only are the yields on these investments quite high relative to other investments, but the interest rate risk might be quite low. After all, the Federal Reserve probably won’t raise rates dramatically in the near future. Instead, rates are more likely to see a gradual move higher. At the same time, however, investors are faced another important question. Namely, after the 14-month 48% gain in the DJ REIT Index, have shares in the sector become overvalued? Was there perhaps a bubble in the REIT worlds? If so, judging by the 6-day 16% slide in the DJR, the bubble appears to have been pricked; and this may serve as a warning sign about the risks inherent in some of the more interest-sensitive sectors of the stock market.


Frederic Ruffy
Senior Writer & Index Strategist
Optionetics.com ~ Your Options Education Site
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