REITs Are Battered. It Could Be Time to Nibble on a Few.

While REIT returns are a little better this year—Vanguard Real Estate is up about 0.2%—investors should be cautious. “We’re still looking for another potential downside in the market—call it 10% to 15%—before we feel like a lot of this risk is priced in,” says Ronald Kamdem, head of U.S. REITs at

Morgan Stanley

—though he sees opportunities in some individual names.

Kamdem says three factors must fully play out before the risk is fully reflected in the broad REIT market.

The first—a reduction in REIT earnings projections—mostly has occurred, he says. The second—a cut in profit estimates for S&P 500 companies, often prime tenants of properties in which REITs invest—“mostly hasn’t happened,” he says. As for the third—a downturn in private-market real estate values—while prices have fallen, Kamdem expects to see a further decline.

Worrisome for REIT investors are the problems of regional banks, a big source of commercial real estate loans. A pullback in lending could be devastating for the property markets.

Everything isn’t gloom and doom, however. Though hardly stellar, REITs’ stock-market performance has improved a bit from last year’s rout. The FTSE Nareit All Equity REITs Index has returned 0.3%, including dividends, in 2023. Measured the same way, industrial REITs, whose holdings include warehouses used by shippers, have starred, returning nearly 8%, on average. And single-family home REITs have climbed 6%.

The office sector, however, has been clobbered by the profound changes in working arrangements triggered by the pandemic. It’s down 17% this year.

That sector “is facing secular headwinds, not cyclical,” says Brent Dilts, a real estate analyst at Columbia Threadneedle Investments. “Work from home and hybrid work are the new go-forward structure.”

Some encouraging signs are on the horizon. Among them: the strong likelihood that the Federal Open Market Committee is close to finishing its rate boosts. An end could come at its next gathering in May.

And REITs remain popular with income investors. A big reason: They’re required to distribute at least 90% of their taxable income to shareholders, giving them bondlike characteristics. At the same time, real estate investment trusts are capital-intensive, and many have big debt loads.

So, even a pause in the Fed’s rate hikes would be a welcome respite for the sector. Dilts calls this environment “a cyclical low point for REITs.” But he adds that they “tend to start to outperform the further you get out from the end of rate hikes.”

REIT performance was good overall during the pandemic, as property occupancy and cash flow generally remained strong. The sector started to go south about a year ago, shortly after the Federal Reserve began to boost short-term rates.

Typically, Dilts points out, REITs tend to outperform the broader stock market 18 months after the Fed ceases hiking interest rates. But that’s still a ways off, given Fed Chairman Jerome Powell’s comments that the fight against inflation isn’t over.

Looking ahead to whenever the central bank actually does start to reduce rates, possibly amid a recession, REITs could benefit. If “the Fed stops raising, and there isn’t a hard landing, that’s really good for the REITs,” says Kamdem. “There’s slow growth, but not a recession—and their financing costs are coming down.” But, he adds, if “the Fed is cutting, and GDP is falling off a cliff, [that] isn’t good” for REITs.

One lure for investors who want to nibble at a property trust or two right now is valuation. Michael Knott, head of U.S. REIT research at analytics firm Green Street, says that publicly traded real estate is less expensive than property in the private market. REITs, he says, can offer “a cheaper way to buy real estate today.”

Kamdem considers industrial real estate investment trusts to be well positioned, with good growth opportunities and sound business models.

One member of that group is

Prologis

(PLD), which yields 2.8% and whose stock returned 9% this year through April 5. The company owns various logistics facilities, including warehouses, across four continents. Its tenants include

FedEx

(FDX),

Amazon.com

(AMZN),

Home Depot

(HD),

United Parcel Service

(UPS), and

Walmart

(WMT).

Kamdem also cites

Agree Realty

(ADC), which yields 4.3%, and

Gaming & Leisure Properties

(GLPI), yielding 5.6%.

Agree Realty, whose shares have returned about minus 5% this year, has a long list of tenants on long-term leases. They include Walmart,

Dollar General

(DG),

Tractor Supply

(TSCO),

CVS Health

(CVS),

Best Buy

(BBY), and Lowe’s Cos. (LOW)—all of which should be pretty durable in an economic downturn.

Another real estate investment trust, Gaming &Leisure Properties, has casinos and other gambling facilities across the U.S. It owns substantially all of

Penn Entertainment
’s
(PENN) former properties, according to a filing. An additional GLPI tenant is

Caesars Entertainment

(CZR). Gaming and Leisure Properties’ stock is about flat in 2023.

It wouldn’t be smart to bet the house on REIT stocks at the moment, given their risks, but a nibble or two is worth considering. Like Rome, a sound realty portfolio isn’t built in a day.

Write to Lawrence C. Strauss at [email protected]