Publicly traded real estate investment trusts ("REITs") continue to be a popular investment choice for all types of investors. According to the National Association of Real Estate Investment Trusts ("NAREIT"), 83% of registered investment advisors recommend REITs to their clients. Additionally, 92% of surveyed advisors plan to increase or maintain their use of publicly traded REITs in the next 1-3 years.
While the REIT sector has experienced a pullback recently, it still offers competitive long-term performance and stable dividend yields. In fact, REIT dividend yields are currently more than double that of other components within the S&P 500 (SPY).
In this article, we will discuss the current state of REITs, opportunities embedded in the sector, the associated risks, and highlight top industry picks for 2023.
Current State of REITs
YTD through November 30, 2022, the FTSE NAREIT All Equity REIT index ("FTSE-A.E.R") has seen a decline of 21%. While this underperformance may raise concerns, it's important to note that the FTSE-A.E.R index has outperformed the S&P 500 in 15 of the last 25 years, offering higher dividend yields as well.
However, most sectors within the REIT market have experienced significant declines. Bellwether sectors like Industrials and Infrastructure are down 26% YTD. The underperformance of these sectors has contributed to the overall decline in REITs, as they are core holdings in various real estate funds.
One of the worst-performing sectors is Offices, with a YTD decline of over 30%. The rise of hybrid working arrangements and an oversupply of lower-quality buildings have caused investor flight and weighed on property values.
However, the Specialty sector is a standout performer, with a positive return of about 3.5%. Components within this sector, such as VICI Properties, Iron Mountain, and Gaming and Leisure Properties, have posted positive returns and outperformed the broader markets.
Opportunities Embedded in REITs
The recent underperformance of the REIT sector has created an attractive entry point for investors. REITs not only offer steady dividend income but also provide the opportunity for better portfolio diversification.
According to NAREIT, REITs have a correlation to the total stock market of just over 0.60 from 1997-2021. This is notably lower than the correlation of large-cap indexes and demonstrates REITs' potential to offer diversification benefits.
REITs have a straightforward business model where they primarily lease space and collect rent on the real estate. At least 90% of their taxable income is distributed as dividends to shareholders annually. This simplicity allows investors to easily track and compare sector performance.
The Current Risks Associated With REITs
Despite the opportunities and advantages, prospective REIT investors should be aware of the associated risks. One of the risks is the relatively higher debt loads compared to broader market indexes. Although REITs have reduced their debt levels over the years, it still generally tracks higher than other market indexes.
Another risk is the potential impact of rising interest rates. Higher rates increase refinancing-related risks and present attractive alternatives to income-focused investors.
Competitors to REITs
REITs historically have provided a solid hedge against inflation due to rent adjustments tied to CPI-related data. However, attractive alternatives with higher yields have emerged, posing a challenge for REITs to attract new investment.
Recent News
Recent news in the real estate market includes Blackstone's real estate fund, BREIT, limiting redemptions after exceeding withdrawal limits. This has raised concerns and affected investor sentiment. Additionally, U.S. public pension funds have reduced new investments in commercial real estate, leading to lower capital deployment and pressures on property sales and values.
Top Industry Picks for 2023
Healthcare
Healthcare REITs are considered safe bets for investors seeking defensive sectors. Despite the YTD decline in Healthcare REITs, the long-term demand for medical office buildings and skilled nursing facilities remains strong due to the aging population. Medical Properties Trust and Omega Healthcare Investors are two names within the sector that offer upside potential and attractive dividend yields.
Self-Storage
Self-storage is another needs-based industry that deserves attention in 2023. Although down YTD, the sector has a track record of performing well during economic downturns. Increased demand for storage during both good and bad economic times makes this sector resilient. National Storage Affiliates is a top name in the sector, offering attractive valuations and a strong dividend track record.
Industrials
Industrials, with their low vacancy rates and pricing power, are expected to rebound in the coming periods. Some Industrials names have already experienced a decline in share prices despite sound operating results. Plymouth Industrial is one such name that presents upside potential, trading at a lower forward FFO multiple compared to the sector median.
Offices
Despite the current decline in the Offices sector, it still holds promise for significant rebound in 2023. Many major office components continue to report strong leasing figures with long lease terms. Occupancy levels are increasing, particularly in the Texas market. Piedmont Office Realty Trust and Highwoods Properties are two names to watch in the Office sector, offering attractive valuations and dividend yields.
Takeaways
REITs have underperformed broader markets, but their long-term prospects remain promising. Defensive sectors like Healthcare and Self-Storage can provide stability during market downturns and offer attractive investment opportunities. Industrials and Offices also have the potential for rebound and should not be overlooked.
It's important for investors to carefully assess the risks associated with REITs, such as higher debt loads and the availability of alternative investment options. By considering these factors and conducting thorough research, investors can make informed decisions to capitalize on the potential of the REIT sector in 2023.