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By Josh Peters, CFA | 02-03-2015 02:00 PM

No Margin of Safety in REITs Today

Although some quality REITs, such as Realty Income and Health Care REIT, are worth holding on to in the current environment, valuations in the sector are too high to justify committing more money, says Morningstar's Josh Peters.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Real estate investment trusts were one of the best-performing sectors in 2014. I'm here with Josh Peters--the editor of Morningstar DividendInvestor newsletter and also the director of equity-income strategy at Morningstar--for an update on the sector. Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: So, what really drove this outperformance of REITs through the year? Was it really just that interest rates kept coming down?

Peters: That's most of it. I've been working with a thesis for the last couple of years talking about a secular shift in the American investment class, if you will, toward more income. And it's really no more complicated than demographics--the numbers that we all know about, baby boomers retiring. And that itself really understates the shift because, a generation or two ago when people retired, they had pension plans. Now, they have 401(k) accounts that need to be converted into income through investment by the individual who owns it. They don't have a pension to fall back on; [they have] some Social Security, but not the classic pension check in the mail.

So, this means that more people are going to focus on REITs and utilities, staples companies, tobacco stocks, and things like that. The really predictable businesses that generate lots of free cash flow and pay the bulk of it out to shareholders as dividends. But if you are going to look just at results in 2014 and here in the first month of 2015, it's really an interest-rate story. At the end of the 2013, the 10-year Treasury got up just over 3%, and people thought that 2014 was going to be the year that the Fed started to crank up interest rates and that the long end of the yield curve would really take off because the economy was going to take off.

Well, the economy did get a little bit better and QE came to an end, but the 10-year Treasury ended the year closer to 2% and then ducked under 2% in the first couple of weeks of 2015. And with that, REITs, it seems, have the tightest correlation of any group of stocks in the market between their valuations and interest rates. And that big, unexpected fall in interest rates--is there any other kind than an unexpected fall or an unexpected rise?--has really inflated (and I think that's the right word, "inflated") the value of most real estate investment trusts that are out there. The cash flows are very predictable, just not as predictable as what you would expect from a government bond. But as interest rates fall, people prize those steady cash flows that much more.

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