Wall Street Is Wrong on REITs

Sometimes Wall Street reminds me of my late border collie, Patch. A story in the Wall Street Journal once described border collies, which are incredibly intelligent animals that are born to herd, as “obsessive-compulsive workaholics.” Just as the stock market typically leads the economy—that is, share prices tend to turn down before a recession and start to rebound before a recovery—border collies want to lead their flock, whether it consists of sheep, cows or people, in a decisive and orderly way.

But because we had no sheep, Patch was always trying to lead me and my kids. We, of course, had minds of our own and went our own way. That left Patch looking over his shoulder and jumping to switch direction so he could stay ahead of us. Every once in a while, he’d look back at me soulfully as if to say: “I could lead you so much better if you’d just tell me where the heck you’re going.”

I imagine Wall Street feels much the same about Federal Reserve Chair Janet Yellen. If only she would clearly state where the Fed was going and what, specifically, it plans to do about short-term interest rates, Wall Street could lead investors in a decisive and orderly way. But because she hasn’t, investors keep changing course. The result is that share prices—including, surprisingly, those of stocks with high dividend yields—have been jumping around like pogo sticks. As my son used to say to Patch, “You need to chill out, dude.”

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Why would I want Wall Street to chill? Because the Street, which is in a tizzy over coming interest-rate hikes that are likely to be far more restrained than the pessimists expect, is putting undue pressure on share prices of real estate investment trusts. I like REITs because they are required to distribute at least 90% of their earnings as dividends, so they provide shareholders with a lot of income. I own three of them in my Practical Investing portfolio: Apollo Commercial Real Estate Finance (symbol ARI, $16, yield 11.2%), Starwood Property Trust (STWD, $21, 9.4%) and Starwood Waypoint Residential Trust (SWAY, $24, 3.2%), which Starwood Property spun off in 2014.

Even before the onset of the stock market correction, REITs were having a rough year. Shares of property-owning REITs began to slide in late January, four months before Standard & Poor’s 500-stock index peaked. In the first nine months of 2015, property-owning REITs lost 3.8%, on average, and REITs that invest in mortgages, as Apollo and Starwood Property do, surrendered 7.9%, on average (the figures include dividends). REIT performance wasn’t dramatically out of line with the overall stock market; the S&P 500 has lost 5.3%, year to date. (All prices and returns are through September 30.)

Rate fears. With their high dividend yields, you might think real estate stocks would have held up better. They haven’t because investors are worried about the Fed’s impending rate hikes and how they would affect high-yielding investments, including REITs. After all, if rates rise sharply, such safe investments as money market funds will pay more and will make REITs seem less attractive. Moreover, because real estate companies borrow money to finance their purchases, rising rates would also likely squeeze their profit margins.

The economy, though, is not growing robustly enough to warrant dramatically higher interest rates. Yellen and crew will probably raise short-term rates by 0.25 percentage point this year, but it may take a while before the Fed pulls the trigger again. In the meantime, such a measly hike won’t provide much competition for my high-yielding REITs, so it looks as if Wall Street is overreacting. We never let Patch lead us astray; you shouldn’t let Wall Street lead you down the wrong path, either.