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Is it time to buy or sell REITs?

I have often written about how I believe that commercial property is a better long-term investment than residential property at the current price levels.

Residential property comes with high levels of gearing, negative cashflow and perhaps lowering values over the coming months or years.

Real estate investment trusts (REITs) are some of the easiest and best ways to get exposure to commercial property. REITs likely have a much lower amount of gearing than the typical LVR of a residential property, pay out a good distribution and can also probably look forward to long-term capital growth.

I often write about some of my favourite REITs such as Rural Funds Group (ASX: RFF), National Storage REIT (ASX: NSR) and Arena REIT No 1 (ASX: ARF).

However, just because REITs are better than residential property doesn’t mean the whole sector is a buy.

There’s an important argument to be made that interest rates could have a large effect on REIT values.

A higher interest rate could mean a bigger interest cost for REITs. This is a big deal because it is easily their largest expense which could increase by a quarter or more in the future.

It could also mean the value of the properties (and share prices) come down because higher interest rates negatively affect asset values.

A lot of REITs offer compelling income yields. But a lot of them could be a yield ‘trap’ like Telstra Corporation Ltd (ASX: TLS) where investors buy a share for a 5% yield and the share price falls 10% or 20% over the next year or two. That doesn’t sound like a good idea to me!

Foolish takeaway

For retirees solely focused on income I do believe that Rural Funds Group, National Storage and Arena will continue to grow their operating earnings and the distribution – I think they’re the best of the REIT bunch, in my opinion most REITs will deliver worse returns than these three.

However, for investors trying to create strong total returns, including capital growth, there could be a better time to buy most REITs in a year or two after US interest rates have risen further. Indeed, it could be worth looking at your portfolio to see how much is exposed to property.

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Motley Fool contributor Tristan Harrison owns shares of ARENA REIT STAPLED and RURALFUNDS STAPLED. The Motley Fool Australia owns shares of and has recommended RURALFUNDS STAPLED and Telstra Limited. The Motley Fool Australia has recommended National Storage REIT. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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