This article is republished with permission from REITCafe.

Encouraging economic news released in August heightened the potential that the Fed will increase interest rates. But this good news proved to be a bit too positive, as it may have contributed to a withdrawal in the real estate investment trust (REIT) sector.

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On one hand, strong property market fundamentals and low interest rates support the sector. On the other,the prospect of higher interest rates, a growing concern that fundamentals are plateauing, and the fact that REIT stocks may be fully valued after a collective increase in recent years have caused investors to worry. The sector’s –3.28 percent monthly return was below broader market indices, but for the year REITs continue to outperform broader markets.

Making news in August was the reclassification of REITs from the broader financial category in the Global Industry Classification Standard (GICS) to a new real property category. The move, which was announced more than a year ago, raises the profile of the equity REIT sector, which has a market cap that now tops $1 trillion, according to the National Association of Real Estate Investment Trusts (NAREIT).

The change for MSCI-managed indexes occurred August 31 and is scheduled for S&P funds on September 16. The strong performance by REITs this year may be attributable at least in part to money flowing into the sector as fund managers reallocated holdings. But because managers have had plenty of time to reallocate holdings, implementation of the change may create little new REIT investment in the last few months of 2016.

In August, lodging was the best-performing equity REIT sector, with a –0.05 percent total monthly return. Hotel demand increased less than new supply during July, but even as occupancy decreased, it stayed at near-record levels for the month. Average daily room rates rose 3.6 percent, according to STR.

Single-family rental homes were also among the better performing REIT sectors for the month. The U.S. Census Bureau reported in August that the rate of homeownership of 62.9 percent in the second quarter was at a 50-year low, which is good news for rentals. Also, Colony Starwood Homes sold a portfolio of 1,675 nonperforming loans for $265 million as part of its strategy to exit the nonperforming loan business.

Specialty REITs dropped 12.85 percent during August, but still rank among the best-performing sectors for 2016. The Bureau of Prisons announced that it would phase out use of private prisons. Then several lawsuits were brought against prison REITs, and before month’s end the REITs’ largest tenant, Homeland Security, announced plans to reevaluate the use of private prisons.

Several major mergers were announced or approved during August. Mid-America Apartment Communities and Post Properties are joining in a $3.88 billion deal that will create the largest publicly traded multifamily REIT, with about 105,000 units. Also, shareholders of Cousins Properties and Parkway Properties approved a merger originally announced in April. The companies are spinning off their Houston portfolios into a new REIT.

On the other hand, New York REIT announced plans to liquidate its assets and distribute proceeds to shareholders after calling off its merger with JBG.

Negative total returns in August reflected growing concerns about REIT valuations and pockets of weakness that are developing in some markets. Still, REIT yields are attractive. August performance likely reflects a temporary market reset (and a buying opportunity for investors), but if the Fed raises interest rates, it could be the beginning of a more prolonged sector downturn.

* TREPP-i Survey Loan Spreads levels are based on a survey of balance sheet lenders. For more information, visit Trepp.com. 

** – 10 yr. Treasury Yield as of 9/2/2016.