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When investors have tax gains across their holdings, many will use the "tax selling" method in stocks as a way to offset gains in other areas. So, when markets have had a bad year, investors will sell their losing positions toward year end to offset gains in real estate and elsewhere. But when all assets are appreciating, there's no tax advantage to selling before year end.
Since there aren't many losses to be taken before Dec. 31 this year, investors may wait until the new year to capture gains in stocks. This way, their tax burden is pushed out until 2017.
This theory explains the bearish January months we've seen over the past three years and supports the case for another one in 2017.
A rising interest rate environment also supports the bearish case for some stocks, and I've found a trade to capitalize on this scenario.
Janet Yellen and the FOMC increased interest rates another quarter point this month, and Yellen made it very clear that she intends on being more aggressive with hikes than previously expected. Some are calling this new, market restrictive policy the "Yellen Collar."
Image by Rob Maystead; Source: PBS.org
Her promise for higher rates will slow down the flow of money in the economy and will also trigger investors to move out of certain income-oriented sectors and into other assets.
How Rising Rate Environments Hurt Real Estate
One of the most rate-sensitive investments is real estate. When interest rates rise, the higher loan costs squeeze profit margins and diminish investors' returns. The affordability of real estate in general also diminishes, leaving fewer buyers who are willing and able to pay more -- a double whammy for real estate profitability.
In other words, real estate investments get a whole lot less attractive.
Real estate investment trusts (REITs) are investment vehicles that that own real estate directly -- from land and office buildings to apartments and even mortgages -- but trade just like stocks. Investors can buy shares in REITs to gain exposure to these various types of real estate.
Revenues come from collecting rent on properties they own (equity REITs) or from interest they earn on mortgages they've purchased or written (mortgage REITs).
In order to qualify as a REIT, these trusts must distribute at least 90% of their net profits to shareholders via dividends. So, when interest rates are low, investors are attracted to their dividend yield. However, that dividend yield usually comes at the cost of higher volatility.
Because REITs trade like stocks, their prices are often affected by broader market forces that have nothing to do with the actual real estate holdings they represent. When rates rise, investors will often pull their dollars out of these trusts and put them into safer investments like bonds -- partly because REITs can be extremely volatile in price, but also because those bonds are now offering a better combination of income and security.
REITs have had a tough 2016, and many analysts are forecasting more stress in 2017. And it's not just rising interest rates that are harming REIT attractiveness and valuation...
Rent Rates Unaffordable, Vacancies Can Only Rise
Apartment rental REITs like AvalonBay Communities (NYSE: AVB), Equity Residential (NYSE: EQR) and Mid-America Apartment Communities (NYSE: MAA) have boomed in the past decade as home ownership dove to 50-year lows while apartment vacancies and rent rates ran to near all-time highs -- the ideal situation if you're a big landlord.
The problem is that these extreme conditions are reverting to normal levels.
Equity Residential, for instance, is already seeing weakness in seemingly unstoppable and tight markets like San Francisco and New York City. And AvalonBay, the second largest apartment REIT in the United States, is seeing lower rent rates for the first time in years.
Analysts have tempered expectations in the sector for good reason. Average rent rates have been moving lower since August, and fell month to month in 55 of the top 100 cities in the United States from October to November. Rents are now up just 1.7% compared to 2015.
The biggest problem here is oversupply. Multi-family development has carried much of the housing market's construction growth over the past few years, and now that rent rates are slowing, it's becoming an industry problem. Recent data show multi-family developments, such as townhouses and apartment buildings, slid 45% to an annual rate of 262,000 units. And increasing interest rates are unlikely to help spur a rebound, especially in the winter months.
On that topic, Q4 is not a booming time for apartments. Most new moves, rent increases and/or promotion occur in the spring and fall, as they are the peak national moving seasons.
So, not only are we in the worst season for apartments in general, there are also real forces in the form of interest rates, lower rents and falling occupancy all coming together to create what I believe will be a very tough quarter for many REITs.
How to Profit From the Bearish Trend
The iShares U.S. Real Estate ETF (NYSE: IYR) holds more than 115 different REITs, including AvalonBay, Equity Residential and Mid-America Apartment Communities. Just like individual REITs, IYR trades just like a stock, except it's much more liquid than most single REITs and also less volatile.
The Trump rally has offered some serious relief for many REITs and for IYR in particular. I believe that conditions in Q4 will be worse than Q3, and that investors will continue their exodus from many REITs as they gravitate toward less volatile income investments.
Despite the rally, IYR remains below its 200-day moving average, which should act as a strong resistance level, helping to prevent a breakout. And a series of lower highs and lower lows tells us the bearish trend remains firmly intact, making a bearish trade attractive here.
My initial downside target is the first big support level of $74.50. That's about 2% below the current price, and while IYR could certainly head even lower, there is a bearish trade that offers a much higher reward for less dollar risk.
In fact, it could amplify a small drop in IYR into double-digit profits before the end of March. And, best of all, the trade risks less than $500. While I don't have the time to go into the details here, if you're interested in learning how it's done, you can get the answer here.
Many investors hold strong opinions about the 200-day MA... but is it actually important?