Investors who have been piling into real estate exchange-traded funds over the past year could be in for a rocky ride if the Federal Reserve raises interest rates later this year as expected.
The record $10.7 billion in new money invested last year in ETFs that focus on real estate investment trusts (REITs), coupled with the $1.2 billion added so far this year, have made these funds pricey: After several of the biggest ETFs returned north of 30 percent last year, the category has an average price-to-earnings ratio of 36.9, according to data from ETF.com.
One popular fund, the iShares Cohen and Steers REIT ETF, for example, has a price-to-earnings ratio of 56.5, more than triple the 17 P/E ratio on the Standard & Poor's 500 stock index.
That could make those funds vulnerable to an interest rate hike because rising rates could spur investors to sell REITs in favor of other yield-generating investments like bonds, to which REITs are often viewed as an alternative.
Vanguard declined to comment on REIT funds in particular, while BlackRock did not immediately comment.
Holders of REITs, which invest in mortgages or properties such as shopping malls and office buildings, have benefited in a low-interest rate environment. The Vanguard REIT ETF yields 3.4 percent, compared to the broader market SPDR S&P 500 ETF's yield of 1.9 percent, and the 10-Year Treasury, which has a current yield of 1.7 percent.
But with the Federal Reserve indicating on Wednesday that it remains on track to raise interest rates this year, REIT funds are likely to take a hit.
"The U.S. real estate market is still recovering, and that's why I like them at the moment because investing in REITs is like investing in U.S. real estate," said John Shearman of Sausalito, California-based IV Lions LLC, who invests in the Vanguard REIT ETF for his clients.
Shearman said he is willing to ride out the bumpy road that REITs may take with rising rates because he is more concerned with their performance in the long term.
"All I care about is, in 10 to 20 years' time, what the investment in VNQ will have done. I think it will have done very nicely," he said.
It may be that some of those continuing to pile into the REIT funds are betting on the opposite scenario: With a weak Europe and a strong dollar, some analysts expect the Fed to continue delaying higher rates.
Coupled with strong fundamentals in some portions of the real estate market, that could insulate REIT investors for another year. Hotel REITs, for example, are favored by analysts at Baird who see high occupancy levels driving bottom-line growth for REITs.
REITs will also vary in their response to rising rates. Properties with shorter leases, such as self-storage facilities, can adapt their operations more quickly to an interest rate hike, said Morningstar analyst Bob Goldsborough.
REELING IN RETURNS
Among the biggest real estate ETFs, the $30 billion Vanguard REIT ETF, which has won $482 million in new assets so far this year, is already up 8.7 percent in the first 18 trading days of this year, the iShares Cohen & Steers Realty Majors Index Fund is up 9.3 percent, and the SPDR Dow Jones REIT ETF is up 8.7 percent over the same period.
The funds returned 30.3 percent, 34 percent and 31.7 percent, respectively, in 2014, far outperforming the broader S&P 500, which rose 13.7 percent.
