Investing in Low-Valuation REITs for Growth and Income

After suffering steep drawdowns this year, many investors with stock-heavy portfolios are looking for assets that don’t always move with stocks. And with inflation at a 40-year high and interest rates rising, investors are also seeking assets resistant to the negative impacts of these trends.

An investment type that satisfies these needs is real estate investment trusts (REITs), an alternative asset (that is, an alternative to stocks or bonds). Often overlooked by individual investors, these publicly traded companies are landlords that own various types of rental property, including apartment complexes, office buildings, shopping malls, data centers and self-storage facilities.

Investing in REITs is a convenient way to get income from rental properties that can be extremely messy to own directly. Though REITs usually involve more risk than bonds, they provide far higher income. They can be essential components of the retirement portfolios of physicians, especially those at small private practices that lack pensions.

Currently, fundamentals and markets of REITs in various categories signal likely growth over the next two or three years. However, today’s negative economic headlines — inflation, rising interest rates, the effects of Russia’s invasion of Ukraine and recession fears — are causing headwinds, and investors are showing reluctance to buy REITs in some sectors. Thus, the clear potential of these REITs has not yet translated into higher share prices.

Less damage

Characteristically, REITs in general have suffered less damage than stocks in the last year’s tumultuous market. In the trailing 12 months as of May 31, the MSCI US REIT Index has returned about +2%, whereas the S&P 500 has returned approximately 0.4% (dividends included). A key reason for this difference is REITs’ attraction for investors as a hedge against inflation (8.5% annually), as landlords can raise rents to cover rising costs. And historically, REIT prices have moved with stocks’ only about two-thirds of the time, so REITs can somewhat diversify stock-laden portfolios.

Fortifying REITs against rising interest rates is their high credit quality, which stems from ownership of hard assets. Moreover, they usually have low debt levels and, depending on the type of properties they own, fixed-rate debt with longer maturities. As a result, increases in short-term interest rates usually don’t have much impact on these REITs’ cost of capital.

One of the best things about REITs is the income they provide in the form of high, regular dividends, stemming from a special tax status requiring them to pay out 90% of their taxable income to shareholders. Many have dividend yields (the percentage of a company’s share price annually paid out to investors) above 4% and some, much higher.

This is generally more than stocks, which rarely have dividend yields above 2% or 3%. Of course, the main goal of owning stocks is to get price appreciation, but investors can get that from REITs, too. Good growth and reliable dividend income represent the best of all possible REIT scenarios.

Time to be greedy

Fear is a strong factor currently holding down some REIT prices. This scenario invokes Warren Buffett’s classic advice for investors to be “fearful when others are greedy and greedy when others are fearful.”

A key metric used to value REITs is the ratio of the price per share to funds from operations (P:FFO). Similar to price-earnings ratios for stocks, this metric represents the price investors must pay to get a given level of earnings.

In late May, the median P:FFO ratio for all REITs was 22.57. Some REIT sectors with good market outlooks remain well below that level. To the extent that these low valuations stem from investor fear, this pricing gap in REIT sectors might signal opportunities for the greedy, in the Buffettesque sense.

Low-valuation sectors

Those REIT sectors include:

Office buildings

In this period of rising interest rates, this category’s specific tendency to rely on floating-rate debt has probably been a turn-off for professional investors, and share prices are still swooning even as postpandemic demand for office space has started to rise.

Fear that office REITs will suffer if more companies make work-from-home policies permanent is likely suppressing interest in office REITs.

But don’t bet the farm on the longevity of work from home. In markets outside major urban centers such as San Francisco, Chicago and New York, the return to the office is well under way as CEOs stress the value of face time and workers see potential benefits from spending time with the boss up close and personal.

As demand for office space increases, so will landlords’ pricing power over rents. In the meantime, share prices of some office REITs, pushed down by the pandemic, remain bedrock low. For example, in late May, SL Green Realty Corp. (SLG) was trading roughly at 2011 or Great Recession levels. Other examples of this sector include Vornado Realty Trust (VNO) and Alexandria Real Estate Equities (ARE).

Regional shopping malls

With a P:FFO of 10.82, less than half the level for REITs overall, this category remains badly beaten up, despite shoppers’ returning to stores in droves this year, boosting bricks-and-mortar sales.

As it turns out, online sales are also up substantially this year. The rise in both types of shopping indicates great potential for retailers who offer both — a tandem model now common to many large department stores anchoring shopping malls and served by salespeople who help in-store shoppers order online if items aren’t in stock. People can still see and feel merchandise, yet stores don’t have to carry as much inventory.

The dominant name in shopping mall REITs is Simon Property Group (SPG), which probably owns almost every high-quality mall you’ve ever walked into. Despite a recent dividend increase (bringing the yield to nearly 6%) and a strong tenant demand outlook for mall space, Simon’s share price was down about 29% for the year as of late May.

The company owns more than 200 properties in 35 states and also operates overseas. The next largest U.S. competitor is Macerich Co. (MAC), with
45 malls. Macerich’s price is down more than 30% this year.

Suburban shopping centers

Also known as strip centers, these are small clusters of retailers where you drop off your dry cleaning and pick up groceries on your way home from work. Typically anchored by chain supermarket or drug stores, these centers also have restaurants, ice cream shops, spas and other small retail establishments as tenants.

Their market niche is convenience for people who want to shop near their homes ­—­ especially attractive during quarantining but also a perennial advantage.

Examples include Urstadt Biddle Properties (UBA) and Kimco Realty Corp. (KIM).

Health care

Unlike hotel or self-storage REITs, the health care category can’t raise rents abruptly because of long-term leases (though they tend to have automatic escalator clauses linked to inflation).

Consumer demand for skilled nursing facilities is slow to return amid fear lingering from publicity about high mortality rates in nursing home populations early on in the pandemic. At the same time, operators have been forced to pay substantially higher wages to compete for employees. But as fears abate and facilities adjust to higher costs, performance, which is currently good relative to share prices, should improve.

Examples include Omega Healthcare Investors (OHI) and Healthpeak Properties (PEAK).

When selecting REITs that rely on local consumer demand, such as apartments, offices and retailing, it’s best to focus on those owning Sunbelt properties. To a large extent, their growth is aligned with population growth, which is currently brisk in the South and Southwest as people move to those regions from crowded population centers in the Northeast and on the West Coast.

In addition, it’s usually better to own REIT shares directly rather than through funds. This way, you won’t end up investing in underperformers included in indexes. And owning directly means you don’t have to share income and appreciation with fund managers.

David S. Gilreath, a certified financial planner, is a 40-year veteran of the financial services industry. He is a partner and chief investment officer of Sheaff Brock Investment Advisors, LLC, a portfolio management firm for individual investors, and Innovative Portfolios, LLC, an institutional money management firm.

Edward “JR” Humphreys II, a chartered financial analyst and chartered alternative investment analyst, is a senior portfolio manager with the firms, specializing in fixed-income and alternative investments. Based in Indianapolis, the firms manage about $1.4 billion in assets nationwide.