Investors are on edge lately as the prospect of higher interest rates threatens their investments in real estate investment trusts, or REITs. 

And they have good reason to worry. When the market dropped 5.6% on the taper tantrum in 2013, the Vanguard REIT ETF (NYSE: VNQ) plunged 15.5% over the five-week period, and that was simply from investor sentiment ahead of rising rates. 

Not only might investor sentiment hit REITs further, but rising rates could hit the shares from an operational point-of-view as well.

While the rest of the market bickers about whether the increase in rates will come in the spring or the summer, nothing short of another economic collapse is going to keep the Fed from raising rates next year. 

When it does, REITs could be in for a tough time even against stronger economic growth. 

REITs & Rates — A Mixed Bag
About the only positive thing you can say about rising interest rates for REITs is that it generally occurs against a strengthening economic backdrop. Economic growth should allow property owners to increase rents and vacancy rates generally come down, especially for commercial property.

The problem is that most properties are leased on long-term contracts with only marginal rent increases each year. It doesn’t do a property owner much good if the economy sours and rents can only be increased by a contracted amount over a ten-year lease. 

Rising rates can hit REITs from an operational standpoint. REITs have been scrambling to lock in rates on debt at longer maturities but near-term exposure is still high. 

Vornado Realty Trust (NYSE: VNO), the largest diversified REIT, holds more than $1 billion in floating-rate debt (10% of total debt) and has $709 million in credit obligations maturing within three years. Higher interest rates mean higher interest expense for companies that are typically highly-leveraged.  

Rising rates also make new real estate developments more expensive to finance. Even if a REIT has a relatively long debt-maturity schedule, it will still need to issue bonds or stock to fund new projects. If rates rise too much, then REITs may decide that dilutive stock issuance is the cheapest way to fund growth.

Rising rates may also limit REIT performance through competition with other yield investments. The dividend yield of 3.5% on the Vanguard fund is extremely attractive against a yield of just 3.0% for bonds of the highest-rated U.S. companies. This has been a tailwind to REITs over last few years as investors stretched for yield.

But that may reverse in 2015. Annual fund flows, from Lipper U.S. Fund Flows data, show an average of nearly $12 billion flowed into real estate mutual funds in 2012 and 2013, against an average of just $4.4 billion over the preceding four years.

Not all REITs Are Created Equal
Not all REITs will react the same way to higher interest rates. Property types with shorter lease durations are more easily able to increase lease rates and benefit from a rising economic tide. 

Multi-family and self-storage REITs may be relatively safe from rising rates. They tend to sign for shorter lease periods of a year or less, meaning they can adjust quickly on a stronger economy. Apartments do well in a rising rate environment because mortgage costs increase, limiting the number of people that buy their own home.

Both property types could continue to benefit from weakness in single-family housing. The Commerce Department reported in July that home ownership hit a 19-year low in the second quarter while rental vacancy dropped to the lowest in nearly two decades.

Apartment Investment and Management Company (NYSE: AIV) is a $4.8 billion multi-family REIT with a portfolio of 236 properties across 36 states and the District of Columbia. 

Not only does the company own properties but it is able to use its expertise to manage properties for other companies. This further reduces interest rate risk and makes the company a cash flow machine. The company was able to push through a 4.7% increase in new lease prices and a 5.0% increase in renewal lease price in the second quarter. 

Shares pay a 3.2% yield with an amazing 29% annual growth in the dividend over the last three years. The REIT trades for 15.7 times the consensus of $2.10 in funds from operations (FFO) for 2014, well below the average for apartment REITs at 20.4 times expected FFO.

Sovran Self Storage, Inc. (NYSE: SSS) is a $2.5 billion self-storage REIT with 401 properties in 25 states. The company also manages 77 properties in which it either owns a partnership interest or holds no ownership.

 The company has been very acquisitive this year, buying assets worth $203 million through the end of July, but expects acquisition activity to slow somewhat in the near-term. This should help the company increase free cash flow and avoid raising capital through debt or equity. 

Shares pay a 3.6% yield with a 14.6% annual growth rate in the dividend over the last three years. Same store revenue increased 8.6% in the second quarter, much higher than the 6.6% average across the four largest self-storage companies. Shares trade at 18.4 times the consensus estimate for $4.20 in 2014 FFO, less than the average 19.5 times expected FFO for the peer group.

Risks to Consider: Self-Storage and Multi-Family REITs are already trading relatively expensively compared to other REITs and rising rates could still bring share prices down on a group-wide shift in sentiment. The two property-types are relatively safer to rising rates and should bounce back after an initial setback as lease rates increase at a faster pace.

Action To Take –> Start shifting you REIT allocation to less rate-sensitive property types well in advance of the Fed’s first rate hike. Within self-storage and multi-family, look for companies that are attractively priced and have stronger fundamentals.

Amid impending interest rate hikes and the current market correction, REITs are a solid way for income investors to earn money. My colleague Amy Calistri runs The Daily Paycheck, an income newsletter designed to put high-yielding investments to work for you… and your retirement. She’s collected $65,000 in dividends in less than 5 years — with a portfolio that’s safer than the S&P 500. The strategy has been so successful, she’s was recently invited to reveal its secrets in front of a live audience at St. Edward’s University. To learn more about The Daily Paycheck strategy — and watch the video of Amy’s live presentation — click here.