Investing in low-valuation REITs for growth and income

Many investors look for assets that don’t move with stocks and are inflation resistant. Are REITs the answer?

After suffering steep declines this year, many investors with stock-heavy portfolios are looking for assets that don’t always track stocks. And with inflation at a 40-year high and interest rates rising, investors are also looking for assets that are resilient to the negative impacts of these trends.

One type of investment that meets these needs is real estate investment trusts (REITs), an alternative asset (i.e. an alternative to stocks or bonds). Often overlooked by individual investors, these publicly traded companies are landlords who own various types of rental properties, including apartment complexes, office buildings, shopping malls, data centers and free storage facilities. -service.

Investing in REITs is a convenient way to derive income from rental properties which can be extremely difficult to own directly. Although REITs generally involve more risk than bonds, they offer much higher returns. They can be essential parts of doctors’ retirement portfolios, especially those in small private practices who don’t have pensions.

Currently, fundamentals and markets for REITs in various categories are signaling likely growth over the next two to three years. However, today’s negative economic headlines — inflation, rising interest rates, the effects of Russia’s invasion of Ukraine and fears of recession — are causing headwinds, and investors are hesitant to buy REITs. in certain sectors. Thus, the obvious potential of these REITs has not yet translated into higher share prices.

less damage

Characteristically, REITs in general suffered less damage than stocks in last year’s turbulent market. Over the past 12 months to May 31, the MSCI US REIT Index has returned around +2%, while the S&P 500 has returned around 0.4% (including dividends). One of the main reasons for this difference is the attractiveness of REITs to investors as a hedge against inflation (8.5% per year), as landlords can raise rents to cover rising costs. And historically, REIT prices have moved with stocks only about two-thirds of the time, so REITs can somewhat diversify stock-laden portfolios.

High credit quality, which comes from owning durable assets, strengthens REITs against rising interest rates. Additionally, they typically have low levels of debt and, depending on the type of assets they own, fixed rate debt with longer maturities. Therefore, increases in short-term interest rates generally do not have much impact on the cost of capital of these REITs.

One of the best things about REITs is the income they provide in the form of high and regular dividends, stemming from a special tax status requiring them to pay out 90% of their taxable income to shareholders. Many have dividend yields (the percentage of a company’s share price paid out annually to investors) in excess of 4%, and some much higher.

This is usually more than stocks, which rarely have dividend yields above 2% or 3%. Of course, the main purpose of owning stocks is to get price appreciation, but investors can get that from REITs as well. Good growth and reliable dividend income represent the best of all possible REIT scenarios.

It’s time to be greedy

Fear is a big factor currently holding some REIT prices down. This scenario invokes Warren Buffett’s classic advice to investors to be “scared when others are greedy and greedy when others are scared.”

A key indicator used to value REITs is the ratio of price per share to funds from operations (P:FFO). Similar to stock price-earnings ratios, this measure represents the price investors must pay to obtain a given level of earnings.

At the end of May, the median P:FFO ratio for all REITs was 22.57. Some REIT sectors with good market prospects remain well below this level. To the extent that these low valuations stem from investor fear, this price gap in REIT sectors could signal opportunities for foodies, in the Buffettesque sense.

Low valuation sectors

These REIT sectors include:

Office buildings

In this period of rising interest rates, this category’s specific tendency to rely on floating rate debt has likely deterred professional investors, and stock prices continue to slump even as demand post -pandemic office space began to increase.

Concern that office REITs will suffer if more companies make work-from-home policies permanent likely suppresses interest in office REITs.

But don’t bet the farm on the longevity of working from home. In markets outside of major urban centers such as San Francisco, Chicago and New York, the return to the office is well underway, with CEOs emphasizing the value of time spent in person and workers seeing the potential benefits of spending time with the boss up close and personal.

As the demand for office space increases, the pricing power of landlords over rents will also increase. In the meantime, the share prices of some office REITs, pushed down by the pandemic, remain very low. For example, at the end of May, SL Green Realty Corp. (SLG) was trading around 2011 or Great Recession levels. Other examples in this sector include Vornado Realty Trust (VNO) and Alexandria Real Estate Equities (ARE).

Regional shopping centers

With a P:FFO of 10.82, less than half the overall level for REITs, this category remains hard-fought, despite the massive return of shoppers to stores this year, boosting physical sales.

It turns out that online sales have also increased significantly this year. The rise of both types of shopping indicates great potential for retailers offering both – a tandem model now common to many mall-based department stores and served by sales associates who help in-store shoppers order online. line if the items are not in stock. People can still see and smell the merchandise, but stores don’t have to have that much inventory.

The dominant name in shopping center REITs is Simon Property Group (SPG), which probably owns almost every high-quality shopping center you’ve ever walked into. Despite a recent dividend increase (bringing the yield to nearly 6%) and a strong prospect of tenant demand for commercial space, Simon’s share price was down about 29% for the year at the end of May.

The company has more than 200 properties in 35 states and also operates overseas. The second largest US competitor is Macerich Co. (MAC), with
45 shopping centers. Macerich’s price is down more than 30% this year.

Suburban malls

Also known as strip malls, these are small groups of retailers where you drop off your dry cleaning and pick up your groceries on your way home from work. Typically anchored by supermarket or drugstore chains, these centers also have restaurants, ice cream parlors, spas and other small retail establishments as tenants.

Their market niche is convenience for people who want to shop close to home – particularly attractive during quarantine but also a perennial benefit.

Examples include Urstadt Biddle Properties (UBA) and Kimco Realty Corp. (KIM).

Health care

Unlike hotel or self-storage REITs, the healthcare category cannot increase rents sharply due to long-term leases (although they tend to have automatic indexation clauses linked to inflation ).

Consumer demand for skilled nursing facilities is slow to return amid lingering publicity scare about high death rates in nursing home populations early in the pandemic. At the same time, operators were forced to pay significantly higher wages to compete for employees. But as fears ease and facilities adjust to rising costs, performance, which is currently good relative to stock prices, should improve.

Examples include Omega Healthcare Investors (OHI) and Healthpeak Properties (PEAK).

When selecting REITs that rely on local consumer demand, such as apartments, offices, and retail, it’s best to focus on those that own Sunbelt properties. To a large extent, their growth is in line with population growth, which is currently rapid in the south and southwest as people move to these areas from the crowded population centers of the northeast and west coast. .

Also, it is generally better to own REIT shares directly rather than through funds. This way, you won’t end up investing in underperformers included in the indices. And owning directly means you don’t have to share income and appreciation with fund managers.

David S. Gilreath, a Certified Financial Planner, is a 40-year veteran of the financial services industry. He is a partner and chief investment officer of Sheaff Brock Investment Advisors, LLC, a portfolio management firm for individual investors, and Innovative Portfolios, LLC, an institutional money management firm.

Edward “JR” Humphreys II, Chartered Financial Analyst and Chartered Alternative Investments Analyst, is a senior portfolio manager at companies, specializing in fixed income and alternative investments. Based in Indianapolis, the companies manage approximately $1.4 billion in assets nationwide.

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