Bond yields remain low, inflation is ticking up, and stock valuations look lofty. That all sounds like bad news for investors—but those holding real estate investment trusts may stand to benefit.
REITs are companies that own, operate or finance property such as offices, shopping centers and apartment buildings. They’re required to distribute at least 90% of their taxable income to shareholders, so they tend to offer generous dividends. That income, combined with potential stock-price appreciation, can help investors outpace inflation. And a dose of real estate can be a diversifier: REITs tend to have low correlations with the broader stock market and with bonds.
There are currently some bargains to be found among REITs focused on shopping centers, senior housing, data centers and other property types, analysts and money managers say. But income-focused retirees need to pick their REITs carefully and resist the temptation to pounce on the juiciest yields. While there are REITs yielding 10% to 12%, these often use leverage, or borrowed money, to boost their income, and they may be hit hard as interest rates rise, says John Buckingham, chief investment officer at AFAM Capital, in Aliso Viejo, Calif. Older investors should set realistic return expectations and expect some volatility, he says.
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REITs have not been the life of the market’s party lately. Some have been weighed down by fear that rising interest rates will lure yield-hungry investors away from income-producing stocks and into bonds. They’ve also been hurt by sector-specific concerns, such as worries that the rise of online shopping will annihilate malls. And while large growth stocks, particularly technology names, have been market darlings, REITs have been left in the dust. The real estate sector gained just 1.4% in the 12 months ending in early August, while Standard & Poor’s 500-stock index climbed 14.5%.
But in many cases, the fears dragging down REIT returns are overblown, analysts say. Consider rising rates. Yes, higher yields have made bonds moderately more attractive to income investors. But rising rates also tend to go hand in hand with an improving economy, as we’re seeing now. And when the economy is growing, tenants tend to rent more space and pay higher rents. Looking at months between March 1981 and December 2017, REITs have delivered average annualized returns of 12.5% when growth was improving and bond yields were rising, beating the S&P 500 by 1.7 percentage points, according to money-management firm Cohen & Steers. “History tells us that what’s most important to the asset class is the trajectory of the economy, not the trajectory of rates,” says Brian Cordes, a senior vice president at Cohen & Steers.
As inflation heats up, REITs may also offer investors an edge. In the 12 months ending in July, core inflation (which excludes volatile food and energy prices) rose 2.4%, the biggest gain in nearly a decade. So how do REITs stack up against other asset classes commonly considered inflation-fighters? Brad Case, an economist at Nareit, an industry association, compared REITs against commodities, Treasury inflation-protected securities and gold. Since the start of 1978, REITs have beaten the inflation rate in 68% of six-month periods when inflation was above the long-term median annualized rate of roughly 3%, Case found, versus 69% for commodities, 65% for stocks, 57% for TIPS and 43% for gold. REITs also delivered the second-best returns during low-inflation periods, Case found. “The point is, get something that’s going to do well for you when inflation is high,” he says, “but not hurt you when inflation is low.”
Building a REIT Portfolio
For investors interested in individual REITs, data centers are one promising hunting ground, analysts say. These REITs, which own facilities that companies use to store data, stand to benefit as companies increasingly outsource their information-technology infrastructure, Cordes says.
More and more data is being stored in the “cloud,” and “it’s not up in the sky—it’s in giant warehouses” owned by data center REITs, Buckingham says. He favors Digital Realty Trust (DLR, recent price $121, forward dividend yield 3.3%), which holds data centers that store and process information as well as those that serve as Internet communication hubs. The company has boosted its dividend for 13 consecutive years.
Health care REITs, which hold properties such as medical office buildings, senior housing and skilled-nursing facilities, also offer opportunities for investors, says Kevin Brown, analyst at investment-research firm Morningstar. Some of these names have been hurt by an oversupply of senior housing, but over the next several years supply growth should slow as construction costs climb—and demand should pick up as baby boomers hit their mid seventies, he says.
Brown likes Welltower (WELL, $63, 5.5%), which provides capital to senior-housing operators and post-acute care providers. They “really do a good job of working with their operators” to boost performance, he says, and with their large exposure to senior housing, “that will translate well over the next decade as baby boomers move into the space.”
Contrarian investors may find values among shopping centers, which have been bruised by the rise of Amazon and other e-commerce giants. “These stocks are priced for the worst-case scenario,” Cordes says. But job growth and tax cuts are boosting consumer confidence, he says, and “we’ve seen less store closures and bankruptcies this year.”
Buckingham likes two shopping-center REITs: Kimco Realty (KIM, $16, 6.8%) and Regency Centers (REG, $63, 3.5%)—both quality names with high occupancy levels, he says. “The perception is that Amazon is going to kill any mall-based retailer, but if you’ve been to a mall lately, there has been a resurgence,” he says. “The tenants have actually posted solid results.”
If you’d rather leave the stock-picking in the hands of an expert, consider real-estate focused mutual funds with low fees and strong long-term track records. T. Rowe Price Real Estate (TRREX), which charges fees of 0.73% annually, has beaten roughly 70% of its category peers over the past 15 years, with a 9.7% annualized return. Cohen & Steers Realty Shares (CSRSX) charges fees of 0.97% annually and has outpaced 94% of peers over the past 15 years, returning 10.5% annually.
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