More than a year of interest rate hikes by the Federal Reserve pushed down returns on real estate investment trusts, or REITs. While higher rates negatively impacted nearly every sector of the economy in 2022 and most of 2023, real estate was hit especially hard. Rising interest rates hurt not only the value of REITs’ property holdings but also the cost of debt to finance those properties or even refinance already-owned assets.
But now with the Fed likely ending rate increases and rate cuts on the horizon, are REITs poised for a recovery?
What are REITs?
Real estate investment trusts, or REITs, are a way to invest in real estate without directly owning properties. A REIT is a company that owns, finances or manages properties and then is required by law to pay most of that income to investors. Shares of publicly traded REITs can be bought and sold on major stock exchanges.
Many kinds of real estate exist — from medical centers to warehouses to residential apartment complexes — but most REITs focus on a particular property subsector. However, a few do hold multiple types, such as retail properties and office buildings.
REITs tend to be popular among income investors because they’re required to distribute at least 90 percent of their taxable income as dividends to shareholders. So, for investors, there are two ways to make money from REITs: Appreciation when the REIT’s share price goes up and regular quarterly dividend payouts.
How have REITs been performing?
REITs had a hard go of it starting with the bear market of 2022. The Fed began aggressively raising interest rates, which is historically bad news for real estate. When interest rates rise, it becomes more expensive for REITs to borrow money used to fund acquisitions and development projects and hurts the value of assets they already own.
Negative headlines about empty office spaces emerging across the U.S. following the Covid pandemic and the shift to remote work may have also scared away investors. But REIT proponents would be quick to point out that only a small percentage of REITs invest in office spaces. Also of concern are decreased asset values and declining cash flows due to crimped margins brought on by rising rates.
After the Fed signaled in December that it’s effectively finished raising interest rates, the REIT sector quickly rebounded. The Dow Jones Equity All REIT Index dropped 8.4 percent in the third quarter, but rebounded 17.9 percent in the fourth quarter. The strong finish helped buoy the index for the entire year, which ended with an 11.3 percent gain.
Both rate pauses and rate cuts tend to bode well for publicly-traded REITs. When interest rates stabilize, it tends to make REIT valuations less volatile because it reduces the uncertainty in future cash flows, making it easier for investors to assess and value real estate assets.
Is now a good time to buy REITs?
A temporary shake-up caused by higher interest rates seems to be ebbing, which could spell good news for REITs.
Historically, REITs tend to deliver their highest returns during early stages of the real estate recovery cycle, according to research from Nareit, an association representing the REIT industry. That could spell a strong performance for REITs moving forward.
In fact, REITs typically achieve forward-year returns around 20 percent during the early stage of an economic expansion, according to research from Cohen & Steers, a global investment manager specializing in real assets.
It’s important to note, though, that past performance isn’t a guarantee that REITs will perform well in the future.
The generous dividend payments enjoyed by REIT investors may look particularly attractive moving forward. With rate cuts on the horizon, dividend yields for REITs may look more favorable than yields on fixed-income securities and money market accounts.
However, REIT stocks are only as good as the properties they own — and some real estate sectors may be better positioned than others. Malls and downtown office spaces, for example, may have more trouble retaining tenants and collecting rents long term. Malls have faced strong headwinds for years, and it looks like the office space needs to adjust supply to demand, following a multi-year trend of employees working from home.
Which areas might be poised for strong growth? In its 2024 real estate sector outlook, portfolio managers at Fidelity pointed to data centers, senior health care centers and shopping centers as areas of interest.
Other digital infrastructure real estate has performed well and remains a strong prospect over time, while self-storage has been a long-term winner and may continue.
What to consider before investing in REITs
Analysts and talk show hosts may be bullish on REITs at the start of 2024, but it’s necessary to address some drawbacks and potential downsides.
Like any stock, the price of a REIT can roller coaster up and down with the market. While threats of a looming recession are fading, the market is always unpredictable. This volatility is less of a concern for long-term investors focused on those steady dividend payouts, but it does mean that you could lose money if you sell a REIT when the price is down.
It’s also crucial to analyze fundamentals, especially if you’re buying individual REIT stocks. That means doing your homework on the REIT’s financial health, including its debt levels, cash flow stability and dividend history. You should also evaluate the quality of the underlying properties: What type of real estate sector is it? What are its occupancy rates and lease terms? What are the long-term prospects here?
A REIT ETF can be an easier and less risky way to invest, since these funds offer exposure to a large portion of all publicly traded REITs with a single purchase. Exchange-traded funds are safer than buying individual stocks, especially for investors with limited investing experience, and you’ll enjoy the reduced risk of diversification.
However, if the fund is focused on a specific REIT sector, you’ll want to make sure you understand its outlook and past performance. After all, the REIT industry has more than a dozen property subsectors, and some sectors may perform better than others.
Bottom line
Investors eyeing REITs may find a potential recovery ahead. With rate cuts on the horizon, many publicly traded REITs have rebounded, and the industry as a whole seems well-poised for a recovery in the coming year. Ultimately, the decision on whether or not to buy REITs will depend on the specific circ*mstances and risk tolerance of each investor.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
