Can The REIT Party Continue?

| About: Vanguard REIT (VNQ)

The low-growth, low-yield global environment of the past few years made it increasingly difficult for investors to find attractive income opportunities. As a result, U.S. real estate investment trusts (REITs) attracted significant attention, outperforming the S&P 500 Index so far this year (13.7% versus 3.8%) while offering a 3.6% yield (Source: Bloomberg data as of 12/2/2016). As the chart below indicates, REITs offered one of the highest dividend yields and more dividend growth than any other sector in the S&P 500.

Recently, however, REITs-like bonds and other bond-like proxies have been caught in the post-election selloff. Historically, income-oriented asset classes such as REITs have been vulnerable to increases in interest rates. Bond yields have risen because growth and inflation expectations are rising amid a general perception that a Trump presidency will result in stronger economic growth.

Still, a couple of factors suggest that REITs can withstand the recent market aversion to income assets. Although the Federal Reserve (Fed) raised its benchmark interest rate this week, as the market expects, future hikes are likely to be slow and gradual. We are likely to remain in the "low for longer" interest rate environment for some time, which means demand for income-producing assets will likely persist.

That said, should inflationary expectations rise, causing the Fed to be more hawkish in 2017, REITs may be less vulnerable than some other income assets. They can benefit from their inherent pricing power, which allows them to pass along rising costs to lessees. Therefore, REITs can potentially act as a hedge against inflation, while offering an attractive dividend profile.

Specifically, two sub-industries within the REIT sector - healthcare and residential REITs - may benefit income investors in the current pro-growth environment and offer healthy yields, as the chart below shows.

Healthcare REITs engage in real estate activities relating to the healthcare industry, such as senior living properties, hospitals and other medical-related properties. Demographics, along with government reimbursement rates in programs like Medicaid have been key economic drivers of healthcare REITs. It is important to note, however, that potential changes to or repeal of the Affordable Care Act, including changes to Medicaid payments, promised by the new administration could have an impact on these REITs.

Residential REITs involve multifamily and manufactured homes, apartments and student housing facilities. The primary economic drivers of residential REITS have included job growth, rental demand over home buying, as well as general household formation. Demand for rental properties, particularly in growing urban areas like San Francisco and New York, is likely to continue, which may benefit residential REITs. Indeed, Trump's pro-growth policy of job creation may increase demand for housing.

Recent global market shocks, such as the Brexit vote or the Italian referendum, have also motivated investors to look for investment ideas that may be less impacted by global market volatility. Select pockets within the U.S. real estate market offer U.S. equity exposure potentially less susceptible to global macro influences.

Meanwhile, although REITs are not cheap, especially after this year's strong performance, the attractive yield may continue to intrigue yield-starved investors. For these reasons, investors may want to consider U.S. REITs as part of a balanced portfolio. The iShares Core U.S. REIT ETF (NYSEARCA:USRT) offers low-cost access to a portfolio of diversified U.S. REITs.

This post originally appeared on the BlackRock Blog.

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