Real estate investments will likely rise as rates fall

Investing in real estate: ©Lemonsoup - stock.adobe.com

A common, critical question looms over various investment markets: When will the Federal Reserve Board (the Fed) start cutting the federal funds rate?

Anticipated cuts in that rate will trigger declines in prevailing rates, lowering the cost of loans for pretty much everyone. Corporations will likely benefit because they will pay lower interest rates on their bonds. As corporations would be in better financial shape as a result,Fed rate decreases tend to push up stock values.

Lower interest rates benefit various stock sectors, but few as much as real estate — specifically, landlord companies known as real estate investment trusts (REITs).

REITs lease out all kinds of property, including office buildings, warehouses, apartments, nursing homes, senior housing, data centers and cell towers. Investors buy shares on major exchanges and collect relatively high dividends.

This is a highly convenient way to invest in real estate because investors don’t have to buy, sell or manage property — no late-night calls from tenants screaming that they have no heat or stress from tenants not paying their rents on time. Instead, investors just buy shares.

As REIT price movements have lower correlation to those of other assets — their prices don’t necessarily move in the same direction — these investments can diversify portfolios, reducing risk. However, most individual investors should probably seek only a tincture of this diversification, with portfolio allocations of perhaps no more than 15%.

REITs’ relatively high dividends are enabled by a special tax status that requires them to pay out 90% of their taxable income to shareholders as dividends.

But as income plus growth (rising stock prices) is better than income alone, the REIT market is currently focused on the boost that REITs’ stock prices will likely get from Fed rate decreases. Lower interest rates mean lower costs in financing the purchase and renovation of property.

Rates are currently elevated after a series of steep, historically rapid increases in 2022-2023 to counter historically high inflation. Higher rates suppress business activity, slowing economic growth to tamp down rising prices.

Now that inflation has declined substantially and is well on its way toward the Fed’s 2% target, the idea is to lower rates so as not to overdo the dampening, potentially leading to a recession. The question is when to start cutting so as not to fan any lingering embers of inflation.

Amid elevated rates over the past couple of years, REITs have been pretty beaten up, with prices hitting bottom earlier this year. Although some types of REITs have since grown, others continue to languish.

We now know that rate cuts have begun, with the Fed slashing interest rates by 0.5% on September. 18 When the Fed did nothing July 31 to throw water on the notion of a first cut in September, the always forward-looking market, including REITs, got a boost.

Depending on the REIT category involved, this may be a good time for investors to hold on to their shares in anticipation of upward impetus from rate cuts.

But new investors, attracted by current dividends and expectations of growth next year, after likely incremental rate decreases, may find these motivations enough to buy REITs.

Regardless, it’s not too soon for current and potential REIT investors to get a handle on the status of various categories.

Here’s a rundown on the status of five major categories of REITs:

Apartments. Suffering from oversupply, particularly in the Sun Belt, this category doesn’t look ripe for significant price growth, perhaps not even after a rate cut. Long term, apartment REITs can be a good investment because of a chronic shortage of housing in the U.S. But at least for a while, the current abundance of existing apartments and complexes under construction augurs a growth gap, with continued downward pressure on rents, probably for at least 18 months. This will crimp apartment REIT income.

Senior housing. These REITs are currently in something of a sweet spot. Current supply is meeting demand — for now. But rising demand from aging early baby boomers is rapidly using up this supply, increasing previously depressed occupancy rates to profitable pre-pandemic levels. Now about 88%, this rate is fueling strong annual growth. Investable REITs in this category include Welltower (WELL), Ventas (VTR) and Omega Healthcare (OHI).

Office buildings. The trend of working from home, which has a direct impact on corporate demand for office space, is continuing but declining. But even with the work-from-home trend fading, growth in this category may turn out to be quite slow for some time from continued low vacancy rates. Yet investors could be motivated to buy shares of these REITs from their depressed valuations alone; they’ve been so rock bottom that they have nowhere to go but up.And some have been rising sharply this year. The share price of SL Green (SLG), the biggest REIT player in New York office buildings, has grown a whopping 43% year to date after starting at subterranean lows.

Data centers. REITs that own buildings and lease out server capacity to all manner of tech and ecommerce companies are continuing to put out their digital buckets while it rains revenue. The technically capacious needs of artificial intelligence (AI) and cloud storage, along with increasing demand for these leases, are pushing up lease prices. This category will have to keep growing to justify its current values. These are good companies in a highly rewarding industry. With prices rising, though, the issue will be: Are they good values? This may be determined by just how strong the demand from AI usage remains. Major players include Digital Realty (DLR), Equinix (EQIX) and Iron Mountain (IRM).

Hotels. Many major hotels don’t own their properties; they rent from REITs. After a good fourth quarter and a good start to 2024, these REITs have slowed a bit because of diminishing leisure travel as consumers have pulled back a bit. Nearly two years of strong post-pandemic demand from previously cooped-up travelers has ebbed and hotels are now adjusting to more normal demand levels. Though this category isn’t doing as well as it did, it is by no means weak. Examples include Host Hotels & Resorts (HST) and Park Hotels & Resorts (PK), two of the larger companies in this category.

Tom Kaiser, CFA, CPA, and Edward “JR” Humphreys II, CFA, CAIA, are portfolio managers and Dave S. Gilreath, CFP, is a partner and chief investment officer with Sheaff Brock Investment Advisors and Innovative Portfolios. As of June 30, the firms managed assets totaling about $1.4 billion. Investments mentioned in this article may be held by those firms, Innovative Portfolios’ exchange-traded funds and affiliates, or related persons. There may be a conflict of interest in that the parties may have a vested interest in these investments and the statements made about them.