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The Run From REITs Is ‘Overdone’: Morningstar Analyst

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What You Need to Know

  • REITs overall are trading an estimated 20% below fair value, Morningstar analyst says.
  • They must pay most of their net income to shareholders as dividends, so the right REIT can be a good income source.
  • Rising interest rates pose risks for REITs.

Rising interest rates have pressured real estate investment trust shares this year and may cause prices to decline further, but publicly traded REITs nonetheless present an appealing long-term investment opportunity, a Morningstar analyst says.

Morningstar’s U.S. Real Estate Index, encompassing mostly REIT shares, has fallen this year as the Federal Reserve raised interest rates to quell inflation, Kevin Brown, Morningstar senior equity analyst-REITs, noted recently.

The REIT stocks that Brown covers, on average, have been trading at roughly a 20% discount to their fair market value, but the fundamentals are strong, he told ThinkAdvisor last week, expanding on a recent column in which he predicted high inflation will continue to benefit REIT cash flows in 2022. Many companies expect record growth, he wrote.

“I think that the movement out of the REITs because of rising interest rates has been sort of overdone, which is why we think all the names are trading at basically a 20% discount to our fair value estimate,” he said in an interview last week, noting that fair market value represents the level Morningstar analysts expect the companies to reach in three to five years.

Through Friday’s close, the firm’s real estate index was down 3.7% over the prior 12 months, compared with a 7.5% decline in the Morningstar U.S. Market Index. Over the trailing three-month period, however, the real estate index is down 3.5% while the market index is flat, Brown noted.

Share prices may be off but for the most part, REIT sector operations are thriving, with the vast majority of REITs experiencing growth well above historic averages, according to the analyst. That includes companies specializing in hotels, health care facilities, residential apartment buildings, single family rental homes, shopping centers and malls, industrial buildings and self-storage facilities.

Numbers are way up so far in second-quarter earnings reports, with REITs in many property sectors turning single- and low-double-digit net operating income growth into 15% to 20% gains because rents are high, occupancy is at peak levels and the companies have done a good job controlling expenses.

REITs won’t be able to sustain that earnings pace forever, as inflation will eventually come down and many names will have a slight reversion, he said, but “I don’t see any massive correction coming down the road.”

If interest rates keep rising, Brown said, REIT prices will probably fall relative to the rest of the market, but that underperformance would correct itself and shares would return to their long-term valuations, he added. “Long term, these look attractive,” he said.

REIT investors have somewhat priced in recession expectations, so if there’s no recession, shares should quickly recover, Brown said. Should a recession materialize, REITs that are highly correlated to the economy — like economically sensitive non-real estate companies — could see double-digit growth become negative growth, he said.

Risks and Rewards

Like any security, REITs come with risks and benefits, with the advantages including more than an opportunity to realize long-term price appreciation. Notably, these companies can play an important role for income investors. 

“They still provide a very solid dividend for people who are looking for an equity investment that does continue to pay out a strong source of income,” Brown said, noting that REITs are required to pay out 90% of net income as dividends to shareholders in order to maintain their tax-free status.

When interest rates are low, income-oriented investors may take on some extra risk through REITs to gain a higher yield than U.S. Treasurys, he noted. As interest rates go up, however, many investors question why they’re taking on that extra risk when they can get the same income from bonds and Treasurys, which is one reason REITs see outflows when rates increase, he added.

While REITs must pay most of their net income as dividends each year, the large, noncash charges they record for depreciation and amortization in their real estate portfolios may result in a significant difference between net income and the companies’ generally much higher cash flow, Brown noted in a report earlier this year.

Management teams therefore have wide latitude in deciding the dividend payments they distribute to shareholders, and income-oriented investors should make sure their REITs prioritize dividends, he wrote. It’s important to analyze how a REIT has handled its dividend payments historically, including the average dividend yield for the past decade, according to Brown.

Rising interest rates can cause other problems for REITs. Valuations are built on the companies’ ability to grow successfully by buying or developing new assets, Brown told ThinkAdvisor. When debt is cheap, REITs can achieve a good spread between what they pay and what they expect to reap from their investments, but as the cost of capital rises, the spread narrows and some companies place a pause on external growth, he explained.

REITs could face another risk if banks stop lending or significantly raise lending standards, as they did during the 2008-2008 financial crisis, Brown said. “REITs underperformed during that recession as they typically have higher leverage than most companies. That is normally fine because their debt is backed by tangible assets that rise in value over time,” he explained. 

“However, it was an issue during that crisis and can be an issue again if a lot of debt is coming due and banks refuse to provide new loans, forcing the REITs to sell off assets at drastically reduced prices to cover maturing debt. I would say those are the two major REIT risks that aren’t found in most other sectors.”

Of the 27 REITs in Morningstar’s universe, 20 have cut dividends at least once since 2000, with most occurring during the 2008-2009 crisis or the 2020 pandemic recession, he noted in his March report. 

For those seeking steady dividends, he suggested shopping center, health care and “triple net” REITs; triple net REITs typically own buildings with corner stores, like drugstore chains, in which the tenant takes on responsibility for property maintenance, operations and repairs; they generally pay good dividends, the Morningstar analyst told ThinkAdvisor.

“All three should provide steady, stable dividend payments over the next decade,” Brown said.

Hotel REIT dividends, on the other hand, can be very erratic, according to Brown. “You want something that’s going to be a steady investment over time,” he said.

In terms of potential price appreciation, certain sectors are more attractive than others, namely those that have been hurt more by recession fears and while enduring the double whammy from rising interest rates, like hotels and malls, Brown said. 

“They’re definitely the riskiest names short-term but long-term we think they could prove to be the biggest bargains,” he said. A slowdown in the next six to 12 months will hurt those real estate portfolios “but eventually that too will pass,” Brown said.