The negative outlook on REITs is overblown

REIT book © Vitalii Vodolazskyi - stock.adobe.com

REITs, landlord companies that own and lease out various types of property, started 2023 strong but were soon pummeled by a one-two punch. First, rising interest rates pushed up the costs of financing property purchases. Then, in March, some regional bank failures and false assumptions of an ensuing nationwide banking “crisis” triggered questions about the financial wherewithal of REIT tenants and possible follow-on effects on REITs themselves.

These fears turned out to be overblown. The broader national banking system was never really threatened, and data from the Federal Reserve Bank of St. Louis show that delinquencies on commercial real estate loans are now near pre-pandemic levels. There are no visible signs of intense stress on the horizon, as only 1.5% of the $290 billion in outstanding REIT debt is coming due in this second half of 2023.

Moreover, the winding down of the Federal Reserve’s interest rate-hiking cycle will only help REITs, and the rate hike in July may well have been the last of this cycle. The longer the Fed goes without another hike and the closer it gets to rate cuts, the less averse to REITs analysts probably will be.

Overreaction

Despite all this, many investors continue to sniff at REITs because fears linger. This is nothing more than a sustained overreaction to threats that, even if once plausible, concerned transitory conditions.

And perennially, REITs on average pay good dividends, drawn from revenues known as funds from operations (FFO), the REIT equivalent of stock earnings. From 2012 through 2022, overall REIT FFO on average grew tremendously, hitting a record level in 2022. Vanguard Real Estate ETF (VNQ), which mimics the main publicly traded REIT index, paid an annual average of 5.9% during this 10-year period.

Although ascending FFO have funded substantial dividends, investors have not had to pay ascending prices to get them. REIT prices, based on the price of VNQ, were the same in 2015 as in 2007. Astonishingly, prices are at that same level now, although FFO growth, impaired in the first half of this year, has resumed in the third quarter. Such are the effects of fear that bring potential opportunities for the greedy.

Negative views of REITs doubtless are colored by the competitive yields (about 5%) paid by some other income investments, such as money markets. But these have no potential for growth. Sure, unlike money markets, REITs pose a risk to capital, but these risks can be managed with judicious REIT selection. And while investors wait for shares to rise in value, they collect healthy dividends — currently about 4.2% on average.

REITs have a historical pattern of rising 18 months after the final increase in a Fed rate-hiking cycle. That could turn out to be the case this time around. But in this unprecedented post-pandemic economy, which probably will prompt revisions aplenty in economics textbooks, REITs could rise sooner. If they do not, investors will have the consolation of good dividends while they wait.

Category Scenarios

Near-term prospects for REITs vary with the types of property they own. Here is a look at some major categories:

Senior housing. This subcategory of health care has risen well above its low ebb during the pandemic, when COVID-19 shut down many facilities. These REITs have good prospects for continued growth. Some of the best performers have rising occupancy rates, but shares are still trading below pre-pandemic prices. Welltower (WELL) and Ventas (VTR) are nicely positioned.

Retail/mall. In America, retail property that is not strip zoned or housing a grocery store means malls. Before the pandemic, the rap on malls was that they were threatened by online shopping — and they still are. But after the pandemic, shoppers yearning to see and touch products in real life started to venture back into malls, and that traffic continues today. Malls got a boost from the trend of work-from-homers moving from cities to suburbs. The dominant name in mall REITs is Simon Property Group (SPG), the owner of about 100 malls nationwide. Simon has been holding its own, with the price up 8.5% so far this year. Though net operating income is starting to slow, Simon has superior credit to ease purchases and refinancings.

Industrial. A big part of this is warehouses, which benefit from increasing demand from Amazon and other online retailers selling to convenience-conscious consumers shopping more with their fingers than their feet. Revenue forecasts for this category are favorable. The biggest name in warehousing is Prologis (PLG), which owns 1.2 billion square feet of warehouse space in 19 countries. Smaller players include EastGroup Properties (EGP) and First Industrial Realty Trust (FR).

Data centers. These facilities house the servers of corporate clients humming with increasing traffic. REITs owning these facilities benefit from the data tsunami of internet traffic from various types of devices, including refrigerators ordering groceries. Solid performers include Digital Realty Trust (DLR) and the larger Equinix (EQIX). Digital Realty has the larger dividend yield of the two — 4% versus 1.6% for Equinix, making it a better value.

Apartments. This category benefits from the long-term reality that there are not enough places in America for people to live — a problem exacerbated by reduced building for nearly a decade after the Great Recession. Apartment rents benefit from the shorter-term problem of rising interest rates, which make starter single-family homes less affordable, keeping people in apartments longer. Although this is a good category in the long term, performance probably will slow a bit this year as tenants, stung by steep inflation-linked rent increases, look for cheaper rents amid declining inflation and a recent uptick in supply. The best returns are likely to come from REITs with properties concentrated in the Sunbelt, where migration trends sustain demand. AvalonBay Communities (AVB) and Equity Residential (EQR) are standouts.

Office space. Low occupancy in cities like New York has prompted the ironic observation, “the cheapest real estate in America is on Wall Street.” Stung by the work-from-home trend, this is a troubled category that individual investors might consider only for a long-term play. There are signs office space has bottomed and begun to turn around as management starts to trim or eliminate working from home. Those choosing to get in soon should probably avoid office REITs in major cities on the West Coast and in the Northeast, perhaps except for companies with ample Class A space, such as SL Green Realty (SLG), a major owner of Manhattan office space. Yet, as with residential REITs, it generally is better to focus on companies with extensive holdings in the Sunbelt and mid-Atlantic states, where sustained demand is driving population growth and corporate relocations.

Iron Mountain (IRM). This REIT is almost in a category of one because it has no real competition. IRM, a consistent performer with a 4% dividend yield and a recent all-time high price, provides paper storage and the conversion of paper to digital archival storage. Though the company has grown its digital segment and is now getting into data centers, it still does brisk trade in paper storage, driven by legal and regulatory paper-document retention requirements that customers must follow. Customers themselves are also retained, as changing service providers can be complicated, especially when records must be disposed of on a set rotation schedule so as not to over-retain, which can increase potential legal exposure.

Investing directly in real estate involves sizing up property. REIT investors must assess these companies’ ability to size up property and manage it, along with their financial conditions and market positions. By taking a close look at these companies now, investors can make choices enabling good income while positioning for likely near-term growth.

Dave S. Gilreath, CFP, 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, CFA, CAIA, is a senior portfolio manager with both firms, specializing in fixed-income and alternative investments. Based in Indianapolis, Indiana, the firms manage approximately $1.4 billion in assets. The companies mentioned in the article may be held by those firms, Innovative Portfolios’ ETFs, affiliates or related persons. There may be a conflict of interest in that the parties may have a vested interest in the companies and statements made about them.