Are rate-battered REITs worth a second look?

Real estate investment trust shares have been under pressure this year due to rising interest rates, which could lead to more price declines. Nevertheless, publicly traded REITs still offer an enticing long-term investment opportunity, according to a Morningstar analyst.

According to Kevin Brown, Morningstar’s senior equities analyst for REITs, the U.S. Real Estate Index, which mostly includes REIT shares, has decreased this year because of the Federal Reserve raising interest rates to combat inflation.

Brown told ThinkAdvisor that the fundamentals for the REIT stocks he monitors have been generally selling at a 20% discount to their fair market value. Still, he believes rising inflation would continue to favor REIT cash flows in 2022, and wrote many companies are expecting record growth.

“I think that the movement out of the REITs because of rising interest rates has been sort of overdone, which is why we think all the names are trading at basically a 20% discount to our fair value estimate,” Brown noted in a recent interview. Fair market value, he noted, is the level Morningstar’s analysts forecast companies will reach in three to five years.

In comparison to the Morningstar U.S. Market Index, which fell by 7.5% through Friday’s close, the firm’s real estate index was down 3.7% during the previous 12 months. However, Brown pointed out that while the market index is unchanged over the preceding three months, the real estate index is down 3.5%.

While share prices may be down, he said the bulk of REITs are generating growth substantially above historical averages and REIT sector operations – including businesses with a focus on self-storage facilities, hotels, healthcare facilities, apartment buildings, single-family rental homes, malls, and shopping centers – are generally thriving.

Since rents are high, REITs in many property sectors have transformed single- and low-double-digit net operating income growth into gains of 15% to 20%; occupancy is reportedly sitting at peak levels, and the businesses have done a good job controlling expenses. Second-quarter earnings reports have shown numbers that are significantly higher than expected.

REIT prices would likely underperform the rest of the market if interest rates kept rising, according to Brown, but this underperformance will correct itself and shares will eventually return to their long-term valuations.

But as with any investment, REITs have risks and rewards, with the advantages involving more than just the potential for long-term price increase. If banks stop lending or severely tighten lending rules, as they did during the 2008–2008 financial crisis, REITs could be exposed to another risk, according to Brown.

He added that “triple net” REITs, which commonly control buildings with corner retailers like drugstore chains and in which the tenant has responsibility for property upkeep, operations, and repairs, are ideal choices for investors looking for good dividends.