This content is from: Portfolio

REITs and MLPs Offer Value in the Face of an Interest Rate Hike

Real estate investment trusts and master limited partnerships are yield plays that should fare well if rates rise gradually.

  • Dan Weil

Conventional wisdom has it that when interest rates rise, real estate investment trusts and master limited partnerships suffer. That’s in part because REITs and MLPs compete with other fixed-income products on the basis of yield. Another reason is that rising rates increase the cost of capital of REITs and MLPs, both of which are generally heavy borrowers.

But conventional wisdom isn’t always the wisest. Despite the fact that the Federal Reserve is poised to begin interest rate normalization, some fund managers continue to see the appeal in REITs and MLPs.

“If you are concerned about quarterly performance, there will continue to be volatility, but someone looking to generate income can own something with a significant yield,” says Martin Fridson, chief investment officer of New York–based money management firm Lehmann Livian Fridson Advisors.

MLPs and REITs already have seen their shares fall in anticipation of rate hikes. The Alerian MLP index, which consists of midcap and large-cap energy MLPs, has plummeted 16 percent so far this year, hurt also by the now year-long slump in oil prices, and the FTSE NAREIT (National Association of Real Estate Investment Trusts) index has slid 3 percent. As of July 30, the FTSE NAREIT All-REIT index yielded 4.15 percent, whereas the Alerian MLP index yielded 6.96 percent. “Who knows what will happen when rates do go up,” says Fridson, “though a lot has been discounted already.”

Analysts concur with Fridson that with inflation under control, there’s a good chance that the yield curve will flatten following Fed rate increases. Historically, REITs have shown about a 60 percent correlation with interest rates. Tim Ghriskey, CIO at Solaris Asset Management in Bedford Hills, New York, says REITs tend to suffer going into Fed rate increases. “But once the hikes start, they do fine, as long as the rate increases aren’t aggressive.” As for MLPs, says Jay Hatfield, CEO of Infrastructure Capital Management, a New York–based money management firm that specializes in energy and real estate, the idea that rate hikes should hurt them is something of a myth.

If the Fed raises rates, that’s an indicator that policymakers have confidence in the strength in the economy. And that translates into stronger demand for real estate, which would support or even push up prices, Fridson says. He acknowledges that the retail sector of the real estate market is weak, with some stores empty as consumers shift retail purchasing to the Internet. Other sectors are stronger, though. He likes REITs based on cell phone towers. With data usage exploding on mobile phones, the towers that transmit cell signals are sitting pretty. Fridson also favors REITs of assisted living facilities, which stand to benefit by the so-called silver tsunami of baby boomers aging into retirement. In addition, both of these REIT sectors are largely insulated from rising rates, he says.

Kevin Finkel, senior vice president for Resource America, a Philadelphia-based alternative asset management firm specializing in real estate, says properties that will be most exposed to rising rates are ones with long-term leases, which can’t be adjusted to reflect higher interest rates. Generally, hotels and apartments tend to have very short leases, though, so in a rising-rate environment, they have pricing power on their rent. “Our focus now is on multifamily apartment buildings because of the short leases,” Finkel says.

Hatfield says pension fund managers in need of income-generating investments will be attracted to REITs. Meanwhile, much of the MLPs’ decline over the past 11 months has stemmed from the plunge in oil prices, yet their financial performance is largely immune to oil price fluctuation. That’s particularly true of midstream oil and gas pipeline companies, which transport those products. Some MLPs now yield more than 9 percent, and many have recently raised their payouts. Much of their decline stems from some investors, particularly hedge fund managers, unloading them.

“Their revenues aren’t affected by drops in oil prices,” Fridson notes. The companies have long-term contracts for their pipelines, and even if oil and gas companies don’t use all the capacity they contract, they still have to pay for it. “That creates an opportunity — not necessarily one that will pay off next quarter — for value-oriented investors,” says Fridson.

Get more on alternatives.