The average REIT is down roughly 30% from peak levels in early 2022, but don’t give up on well-run landlords.
The Vanguard Real Estate Index ETF, a broad proxy for how real estate investment trusts (REITs) are doing, is down nearly 30% from its high-water mark in 2022. That’s a massive drawdown that will likely elicit worries among conservative investors. But don’t panic. If you stick with high-performing, industry-leading REITs, you should come through this pullback just fine, and with your dividend checks intact.
What’s gone wrong?
There are company-specific problems that have hurt specific REITs. For example, Americold Realty Trust has suffered because of supply chain problems in the food space it serves even as other industrial REITs thrived. There are also property niche problems that have hurt specific property sectors. Office REITs like SL Green have cut their dividends as the work-from-home trend has lingered as the coronavirus pandemic has waned. But from a REIT-wide perspective, one of the biggest problems has been rising interest rates.
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Rising interest rates impact REITs in a number of ways. Directly, interest expenses can go up as the interest rates on variable-coupon debt increase and as fixed-rate debt rolls over. There’s also an impact on the translation environment, as sellers are generally slow to lower asking prices to accommodate higher borrowing costs. Many won’t until there is financial distress, effectively forcing them to sell. These are dislocations that can linger over a long period, but they aren’t new or unusual, and financially strong REITs with good management teams can navigate them (for example, by pushing through higher rental rates).
The other big problem with interest rates is that REITs are income vehicles that compete for investor attention with other income options. With rates notably higher, investors have other options, including safe, government-backed CDs. The drop in REIT prices is, to some degree, increasing dividend yields to better compete. This isn’t new either, though there is little that a REIT can do about what amounts to investor sentiment.
Don’t give up
While REITs are lower as a group, investors shouldn’t react too fearfully here. The best-run landlords haven’t suddenly lost their mojo. Realty Income (NYSE: O) is still the largest net-lease REIT, with a solid financial core, and management continues to invest in the business. Prologis is still an industry-leading industrial REIT with solid financials, and management just agreed to buy 14 million square feet of warehouse space from Blackstone. You could add a lot of REITs to this “still the largest/industry-leading” list, including names like strip mall REIT Federal Realty, apartment landlord Avalonbay, and data center owner Digital Realty.
Yes, the share prices of these REITs are lower, but their dividends remain intact, and are likely to head higher over time. That’s important when you compare a REIT to alternative income options like CDs or bonds, where the income you generate is basically static. That means that inflation eats away at the purchasing power of your income stream. With REITs, dividend increases can help defend your buying power. So even with the REIT pullback, there’s a reason to favor REITs.
Then there’s the growth angle. As noted, Prologis just agreed to buy more properties, effectively growing its business and increasing its ability to support dividend growth. Avalonbay is currently doing the same internally, with nearly $1 billion of planned development starts in 2023. Those investments will benefit the apartment landlord for years to come. When a CD matures or bond comes due, you have to hope you can find a new one at a comparable rate. And your initial capital is all you get back, there’s no underlying growth.
The broad pullback in REIT shares, meanwhile, could actually have a hidden benefit for long-term investors that reinvest their dividends. By doing so, you are buying more shares at a lower price (and higher yield) with each dividend payment. So you are increasing your position and lowering your average cost. If REIT values start to recover, which seems likely at some point, you will end up with greater capital appreciation and more dividend income than you would have had if REITs hadn’t declined.
For investors with spare cash, this could be the opportunity to add to existing positions at attractive prices, or to buy a REIT you have liked but that seemed too expensive. While we can’t know for certain if the REIT sector will stabilize, fall more, or recover, don’t let fear of the unknown stop you from picking up a bargain if Wall Street has offered one. Just make sure to stick with financially strong and well-run REITs. Now is not the right time to take on risky investment choices, but it also isn’t the right time to hide your head in the sand.
Stick out the pain
Even if buying more REIT shares isn’t right for you right now, don’t rush to sell well-run REITs. There are unique situations in the broad sector, like offices, that have notable problems. But overall, REITs are not in a bad place. It is really just investor sentiment that has changed. And since Mr. Market is notoriously fickle, it is probably better to view the drop as an opportunity than a signal that REITs are forever tarnished.
