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.