By Salvatore J. Bruno, Chief Investment Officer, IndexIQ.

Salvatore Bruno, Chief Investment Officer at IndexIQ.

Real estate investment trusts (REITs) are off to a strong start in 2019, with the Morningstar US REIT Index up more than 14% year-to-date through 17 April 2019. On a trailing one-year basis, that number is a little over 17.5%.

What’s behind this? REITs are generally responsive to three factors: the level of interest rates, the real estate cycle, and GDP growth. Interest rates have been up and down over the past year, but have generally been declining following the Fed’s December decision to hold off on further increases to the Fed Funds rate.

At the same time, there’s a growing sense that the economy, while slowing, will continue to expand. A growing economy is generally good for real estate, too – office space is leased, multi-family homes are occupied, and industrial facilities are busy moving goods around. As to real estate itself, there may be some overbuilding in certain property types in a handful of markets, but it does not appear to be universally over-extended.

A roller coaster ride

This all contrasts to early last year when the Fed was raising rates and the expectation was for two or three more increases in 2019. There was a concern then that the economy was heading into a recession. In Q1 2018, the 2-year Treasury yield jumped 39 basis points from 1.88% to 2.27% and REIT returns fell (as measured by the IQ US Real Estate Small Cap REIT Index), losing 9.1%.

In Q2 2018, the 2-year Treasury yield continued to rise but at a slower pace, up 15 basis points from 2.27% to 2.42% at the end of May. In this environment, REIT returns began to pick up, gaining 9.4%.

From June through October, yields began to accelerate once again, going from 2.42% to 2.87%. REIT returns turned down over this period, losing 2.46%. Closing out the year, yields changed course again, dropping 39 basis points. In this instance, the decline was generally ascribed to concerns over decreased growth expectations; based on this REIT returns fell 7.99%.

Unusual volatility

This has been an unusual period of volatility in an asset class that many investors use to generate income. Buy and hold investors – particularly those who reinvest dividends – could have generally ignored all the ups and downs and just collected the income (the IQ US Real Estate Small Cap Index yielded around 6.4% as of 17 April 2019).

We now appear to have entered a period of few or no rate increases on the part of the Fed, and an economy that, while not exactly booming, is expected to grow at a little better than 2.0% through the balance of the year. As a result, we would expect some of the volatility around this asset class to go away.

The fact is that while REITs are often thought of as a yield play, with the expectation that returns on REITs will always be negatively correlated to interest rates (they go down when rates go up and vice versa), the reality is more complex. If rates are rising because the economy is expanding, historically, that’s generally been good for real estate. A modest amount of inflation has generally been supportive, too.

REITs’ fast start this year reflects the new economic reality, and the current Fed holding pattern has, hopefully, taken interest rate volatility off the table for the moment. This should allow investors to return to basics, focusing on the fundamentals of the asset class and the potential for generating income.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)