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Still attractive: As interest rates climb, investors are increasingly turning to property, which is often seen as a hybrid between equities and bonds, as a way of trying to gain the best of both worlds

During periods of rising rates, investors will need to assess whether the additional returns they are generating from asset classes such as equities are sufficient to justify the greater risk over the rising yields being offered on money market securities and other less risky investments. One of the key trends that has been observed in the last economic cycle is that investors are increasingly turning to property, which is often seen as a hybrid between equities and bonds, as a way of trying to gain the best of both worlds.

There are arguments for both. In the short term, higher interest rates may affect capital values and, as a result, property securities and Reits may decline. However, in the long term, as rents will often be indexed to inflation, rental levels and, therefore, yields will rise to reflect underlying economic conditions.

Either way, the high levels of income, relative stability, and low correlations with equities and bonds have made real estate an attractive asset class to many investors, both institutional and private. The shift towards real estate has also been magnified by institutional investors previously being underweight in the asset class.

Tighter spread

One of the key beneficiaries of this shift has been the global Reit market, which provides investors with access to real estate-like returns but with greater liquidity and without the high transaction costs associated with direct investment. As a result, Reits now represent 15 per cent of the total funds allocated to real estate in the US and 25 per cent of funds allocated in Japan. This figure is even greater in other markets with the most advanced level of property allocation - for example, in the Australian and Dutch real estate sectors, where listed real estate represents 70 and 50 per cent respectively of total real estate allocations.

As interest rates rise, the spread between the cost of finance and the returns offered from property in the way of rental yields tightens. The result of this is that many of the highly geared investors are unable to operate in the market. Instead, they are being replaced by larger institutional investors and companies with cash pools to invest, such as Reits, which in the most part have still been able to compete for assets in the current low-yield environment without diluting returns to shareholders.

More selective

As a result, we would expect to see investors becoming more selective when looking at companies, increasingly seeking out those who can add value through effective management or development rather than companies that are purely yield players.

Currently, by historical measures, Reits could be viewed as expensive versus stocks and bonds. However, the fact that Reits remain a relatively new form of investment means that it's unclear how much of the price history represents an initial lack of understanding of the vehicle and corresponding mispricing.

In our view, Reits continue to offer stable, healthy earnings - for example, in the US over the last decade, earnings growth has only been slightly lower than that of the S&P 500 but with less than half the volatility. Importantly, we feel that Reits still look to be good value compared with private real estate in the US. Experience from the US shows us that even in periods of decline in the wider equity market, the higher yields offered by Reits in the form of dividends are likely to offset any capital losses and even maintain a positive total return (as highlighted by the accompanying graph). It's worth noting that there has yet to be a period of negative annual dividend growth in the US Reit market. The overall growth illustrated above coupled with the lower correlation between Reits and the wider equity markets suggests that it is likely that Reits offer benefits within a portfolio even during periods of wider decline.

This article was contributed by Henderson Global Investors' property team