Call me a crazy contrarian, but I’m not convinced that interest rates are headed up anytime soon.
Perhaps a short history lesson can help prove my point. In 1943, investors buying a five-year U.S. Treasury bond were getting a paltry 1.2% yield. World War II was devastating markets around the world, leaving fixed-income investors little choice but to buy local. Besides, the patriotically themed push to buy victory bonds was one of the reasons our side ended up victorious.
Because of the war, the U.S. increased its debt-to-GDP ratio significantly, topping 90%. Soldiers were coming back home, and additional money was needed to spend on social programs easing their transition. Naturally, folks predicted interest rates would jump up. At some point, bondholders started to lose faith in the U.S. government, demanding at least a little more in exchange for holding bonds.
Bonds did eventually rise. The yield on the five-year Treasury note bumped up to 2.2%. The only problem? That didn’t happen until 1955.
I see a lot of similarities between the 1940s and 50s compared to now. Governments around the world have borrowed significantly, and investors seem happy to settle for a low yield. We’ve heard for years now that yields are bound to head up, but they never do. What if we’re in a prolonged low interest rate environment like back then?
It’s simple. Interest-rate-sensitive stocks will continue to perform well. This includes my favorite pick of the REIT sector, Dream Office REIT (TSX: D.UN).
The company is one of Canada’s largest commercial REITs, owning office space across the country with a focus on Toronto and Calgary. It currently owns 186 properties in mostly prime downtown locations, including more than 24 million square feet in leaseable area. Its top tenants are some of the largest companies in the country, as well as various levels of government. These folks aren’t about to skip town without paying the rent.
The company sold off last year when the market feared interest rates were starting to rise, but didn’t join the rest of the sector in rallying when rates softened during the early part of 2014. Part of the problem was because it issued some lackluster results, including an occupancy rate that was below investor expectations but still above its peers.
These minor issues have allowed the stock to become cheap. The company has a $3 billion market cap, yet has a net asset value of more than $3.7 billion. Finding small discounts to NAV is common in the REIT sector, but not a 20% gap.
Besides cheap assets, the company has another thing going for it. Its dividend yield is currently 7.7%, one of the highest in the industry and the stock market in general. However, unlike a lot of other high-yielding securities, Dream’s yield looks pretty solid. The payout ratio is only 90%, and improved in 2013 compared to 2012.
Plus, if interest rates continue to stay low, Dream Office will stand to benefit. Like every REIT, it holds quite a bit of debt, currently at about 40% of assets. Low rates would assist the company in not only servicing this debt, but also securing its dividend.
If you believe that low rates are here to stay for at least a few more years, I think Dream Office REIT is a great choice. It has a terrific yield that looks secure, investors are getting a dollar’s worth of assets for $0.80, and if results improve, there’s even potential for capital gains. For a REIT, that’s about all you can ask for.