Real Estate Investing Is Down But Not Out

real estate investing concept with white house on top of white moving average and blue background

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published 3 September 2023

The lifeblood of real estate is debt, and the Federal Reserve has made borrowing a lot more expensive by raising interest rates five full percentage points between March 2022 and July 2023.

Households owe $12 trillion on their mortgages, and businesses owe $5 trillion in commercial real estate loans. Both sectors are being affected by higher rates and by fallout from COVID. Lately, shares have rallied, but in many cases I find prices attractively low.

First, consider residential property. It's no surprise that existing home sales are expected to fall 16% this year. What's surprising is that new-home sales have held up well, as have prices, which are up about 4%, on average, over the past year. The economy has continued to perk along despite higher rates, with unemployment near record lows. And the COVID experience gave buyers an incentive to own larger homes, with space for offices and recreation.

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After sharp declines at the beginning of the COVID pandemic, homebuilding stocks have rallied. Meritage Homes (MTH, $149) and NVR (NVR, $6,306), which I recommended previously, have since hit all-time highs. My third recommendation, KB Home (KBH, $54), is up 31%. I still like all three as long-term investments, but they are no longer the bargains they were. (Stocks I like are in bold; returns are as of July 31.)

Commercial real estate has been hit by a double whammy: higher interest rates combined with new patterns of work and shopping as a result of COVID. For many businesses with little public contact, a schedule of three days in the office and two at home is becoming the norm. Whether remote work will persist is unknown, but I am a skeptic. Meanwhile, brick-and-mortar retailers are staging an impressive comeback. My guess is that America will continue to revert to the pre-COVID mean.

Vacancy rates are high nationally – an average of 16.1%, compared with 11.5% three years ago. But there are haves and have-nots. A powerful trend is that large tenants are moving from less-attractive buildings to newer, Class A properties when their leases are up. Beneficiaries are real estate companies with better office space or access to the capital needed for major renovations or new construction. A good example is Atlanta-based Cousins Properties (CUZ, $24), which owns mostly Class A buildings in Sun Belt cities and has a dividend yield of 5.3%. Shares are up more than 20% in the past two months but remain far below their pre-COVID high.

The bigger, more stable firms have another advantage. Nearly all income-producing real estate companies trade as real estate investment trusts (REITs). By law, REITs have to pay out at least 90% of their earnings (most pay 100%) to shareholders in the form of dividends. Because REITs retain only a tiny proportion of their earnings, they need to raise debt or equity to grow – a problem during uncertain times. (Also note that REITs don't pay dividends nearly as consistently as conventional corporations do.)

Retail REITs, which lease property to retailers, have managed higher interest rates and changing shopping habits with varying success. Simon Property Group (SPG), the largest in the sector, with more than 232 properties (mainly malls) in the U.S. and Europe, recently took a big hit when its quarterly funds from operations (a metric similar to earnings for a conventional business) failed to meet expectations. Simon is down by about half from its 2016 high, and I would stay away.

I especially like REITs such as Tanger that have niches that provide some protection during downturns. Another example is Alexandria Real Estate Equities (ARE, $126), which leases Class A space to life-sciences and advanced-technology companies, mainly in innovation centers including greater Boston, the San Francisco area, and the Research Triangle area of North Carolina. The REIT has a strong financial base, but it has been caught in the same undertow as other real estate stocks – unfairly, I believe. Shares, which yield 4.1%, are down by more than 40% since December 2021.

Also consider Host Hotels & Resorts (HST, $18), the largest lodging REIT. Host owns 95 properties and partners with top brands, such as Four Seasons and Ritz-Carlton. High-end hotels have staged a strong recovery as COVID has subsided, but Host shares have been largely flat. I also like CubeSmart (CUBE, $43), one of the three largest owners of self-storage properties. The company, which yields 4.6%, is in a business that benefits from its customers' willingness to endure regular rate increases, thanks to inertia and the unappetizing prospect of moving their belongings elsewhere.

This is a delicate time for real estate investing. There are risks. Interest rates seem to have leveled off, but they could still rise, and the economy could falter. Some companies, especially in the commercial sector, will probably fail. But overall, share prices are depressed, many of the stocks offer good income opportunities, and the sector provides a hedge against inflation – a good combination.

James K. Glassman is a visiting fellow at the American Enterprise Institute. His most recent book is Safety Net: The Strategy for De-Risking Your Investments in a Time of Turbulence.