With office vacancy hitting record highs from California to Connecticut, the chorus lamenting all those empty cubicles is now echoing through the halls of Congress, not just from the corner office. In December, Sen. Joni Ernst of Iowa held a news conference urging federal workers to return to the office, putting federal agencies on blast after a report by the Government Accountability Office showed these organizations’ headquarters were being widely underused.
With all the attention paid to empty office buildings, asset allocators might be tempted to shy away from investing in real estate investment trusts altogether. That would be a mistake.
Though REITs have rallied robustly since the summer after a lackluster 2022, analysts and fund managers maintain it’s not too late to allocate a portion of your portfolio to the dividend-rich asset class. REITs investing in cell towers, the healthcare space and multifamily rentals top their list of attractive sectors offering healthier fundamentals and brighter growth prospects than office real estate vehicles.
There’s no question landlords are still struggling to fill offices. But the REIT universe is very diverse, with companies owning, managing and developing everything from office buildings to apartments to retail malls. Each sector has its own fundamental drivers, growth strategy and sensitivity to the economy and interest rates.
“The diversity of property sectors in the publicly traded REIT market is profound,” says Evan Serton, senior vice president and senior portfolio specialist at Cohen & Steers, a New York City investment management firm with $75.2 billion in assets. “Office REITs are only 3% of the publicly traded REIT market. So, there’s 97% of the market that’s in other things, and some of those are enjoying much healthier prospects, much healthier growth.”
Furthermore, despite the recent REIT rally, some analysts believe REITs are still fairly valued. The 197 REITs in the FTSE Nareit All Equity index rose 11.36% for the year ended December 29 after falling 26.29% in 2022. Helped mainly by the expectation of lower interest rates, REITs outperformed the broader U.S. equity market in the fourth quarter.
Still, REITs also traded at a 10.79% median discount to their net asset value (NAV), which is what their assets would fetch in a private transaction, according to S&P Global Market Intelligence. These securities are pricing in the expectation that there will be a soft landing for the economy and that the Federal Reserve will cut interest rates (Fed Chairman Jerome Powell suggested in December that the Fed might at least be done hiking rates).
Many industry observers expect REITs to continue posting positive stock returns in 2024, aided by an uptick in earnings growth. UBS expects the 200-plus REITs it covers to grow earnings per share 3.7% on average from 2023 to 2024 and to yield 4.0%.
REITs essentially are a bet on the movement of interest rates. They rise in a lower rate environment and flounder when rates are high, as they did in 2022. Essentially tax structures, REITs must pay out 90% of their profit in dividends. So they’re a magnet for investors seeking steady dividend income.
Morningstar senior equity analyst Kevin Brown says all of the 19 REITs he covers “are trading at a discount to fair value.” Those fair value estimates are based on the cash flows of the companies, which are forecast 10 years forward; he then determines the terminal value of the overall ongoing enterprise value of those companies.
Brown expects REITs to generate “solid positive performance” over the next few years and for them to outperform the broader equity market if rates fall. He also notes many companies were performing well starting in early 2022, and that drove their revenue growth and net operating income to historic levels as they recovered from the pandemic.
But people who invested in REITs for the dividend yield rotated out of the sector when interest rates rose, since Treasurys became a less risky option. Many REITs are also Krazy Glued to interest rates because the business most times requires companies to load up on debt. Developing a project—whether it’s a skyscraper, office building or college campus—is expensive.
“If interest rates stabilize and potentially go down, people may be able to recognize the value these companies have been able to produce in their portfolios over the past two years,” Brown says.
The analyst also sees healthy growth prospects in the senior housing segment of the healthcare sector, and says he’s recommended companies such as Welltower and Ventas. Older Americans’ spending on healthcare is driving housing demand for senior living facilities. After slumping 22.2% in 2022, the sector has since become relatively upbeat, bouncing back to a 13.9% gain last year, according to the National Association of Real Estate Investment Trusts (Nareit). Healthcare names are trading at a slight 3.2% premium to NAV.
“Senior housing is more defensive than most other sectors,” says Brown. “The sector is all based on demographics.”
The target market for such housing, people above 80 years old, should grow 7% annually by 2027 after growing at a 1.5% pace in the previous decade, he says. After historically slower construction of these facilities during the pandemic, there’s now stronger demand, which could lift occupancy to more than 90% by 2027 from about 83% now.
Brown thinks rising occupancy and strong rental rate growth should produce solid revenue gains in this space. Those growth rates, combined with margin increases, should spur the compound average growth rate of 12% for net operating income over the next 10 years.
Cohen & Steers’ Serton expects REITs to post single-digit to low-double-digit returns in 2024 if real interest rates and REITs’ credit spreads continue to contract amid higher net operating income growth.
Cell Towers Are Different
He notes that not all REITs are affixed to interest rates, contrary to general perception. Cell towers, for instance, are more a play on the expanding digital economy than on dividend income. These REITs offer long-term leases on towers to telecommunication companies such as Verizon, AT&T and T-Mobile.
He points out that the cell tower sector is the largest distinct property type in the FTSE Nareit index, representing 13.86% of it. And he says consumers’ appetite for faster technology such as 5G is pushing the demand for more antennas, which boosts companies’ revenues.
“The prospects of cell tower REITs are obviously very different from the prospects of office,” says Serton. “No matter how the economy is doing, AT&T and Verizon are going to need to hang their equipment on towers.”
But despite a positive outlook for the sector, investors have yet to dial into the cell towers. It was one of the weakest sectors in REITs last year, losing 1.5%, according to Nareit. It fell 28.6% in 2022. But bulls think the sector’s valuation will give investors less sticker shock than the average cell bill. S&P’s telecommunications sector traded at an 11.1% discount at the end of the year, which was slightly cheaper than all REITs.
The largest holding in Cohen & Steers’ $5.3 billion flagship fund, Realty Shares, is American Tower Corp., which has agreed to sell its tower operations in India to Brookfield Asset Management for $2.5 billion to pay down debt and focus on its U.S. cell tower and data center operations.
Too Many Apartments
While the oversupply of apartments is hurting the multifamily market, Cohen & Steers is finding the single-family rental sector more hospitable. That sector rose 20.6% last year, after dropping 31.9% in 2022, Nareit says. S&P’s residential sector traded at an 11.9% discount at the end of last year.
Serton says that some property types let landlords increase rent even in more challenging economic environments, and says apartment REITs are benefiting as people move from large urban areas to regions like the Sunbelt. Meanwhile, millennials who have entered their prime home-buying years are turning to renting homes instead of taking on high-rate mortgages.
Office Discount
The office sector rallied sharply in the fourth quarter with the rest of the REITs, but it trades at the largest discount, at a median 28.1%, and for good reason. The calls from corporations and politicians imploring workers to come back to the office have mostly fallen on deaf ears, and hybrid work seems likely to stay. That means it’s mostly a stock picker’s market, and giants like Boston Properties, which owns a ton of Class A properties in Manhattan, are top picks.
For the most part, analysts like Todd Lowenstein, managing director and chief equity strategist at HighMark Capital Management, are avoiding the office sector altogether, seeing “further shakeout in commercial real estate.”
“There’ll be some attractive opportunities emerging after that reckoning,” Lowenstein says.
In the meantime, sector allocators seeking steady dividend income can find a home in several other fundamentally sound REIT markets.