In this podcast, Motley Fool analyst Deidre Woollard and Motley Fool contributor Matt Frankel discuss:
- How REITs differ from stocks.
- Publicly traded REITs vs. private REITs.
- One office REIT that’s evolving.
- Ways to spot a yield trap.
- REITs benefiting from e-commerce trends.
To catch full episodes of all The Motley Fool’s free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.
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This video was recorded on Jan. 21, 2023.
Matt Frankel: The whole premise of a REIT is that it’s not economical for all of these businesses to own their own real estate. It’s not economical for companies like Walgreens to own the buildings they operate in, which creates an opportunity for companies like Realty Income. There’s a whole bunch of examples like that where it just doesn’t make sense to own your own real estate. That’s one thing that I think the market’s really overlooking when it comes to data centers.
Chris Hill: I’m Chris Hill and that’s Motley Fool contributor Matt Frankel. Despite a down market, some real estate trends aren’t going away. That’s part of what Deidre Woollard and Matt discuss in this episode, along with the fundamentals of REITs, how to spot a yield trap, and investment ideas in warehousing, retail, and a couple of ETFs.
Deidre Woollard: Not a great year for REITs in 2022. The FTSE, the all-equity REIT number for the year, that came in at a negative 24.95%. That’s not great. It’s below the S&P, it’s below the Dow. Not as bad as the Nasdaq, tech had a worse year than REITs, but 2021, REITs were total rockstars. Usually, REITs are the steady part of my portfolio. What’s the story here? What’s the volatility? Why did this happen this way?
Matt Frankel: You’re right in the sense that REITs usually aren’t so volatile, but you have to remember that neither are interest rates. Interest rates have been particularly volatile this year. Usually REITs move a whole lot slower than they have over the past year. It’s really rare for, say, the mortgage rate to double in a single year. REITs are very rate-sensitive instruments. They’re designed to pay out steady income, and income-focused investments generally are very sensitive to changes in yields. When you think about it this way, if the 10-year Treasury is paying 2%, a REIT index fund that’s paying 4% seems pretty appealing to income investors.
But if the 10-year Treasury that’s risk-free is paying 4%, all of a sudden, a 4% yield from a REIT fund might not seem that appealing. In order for REITs to keep up with the market, rates have to rise, the yields have to rise, and because yield and price have an inverse relationship, it generally puts a lot of pressure on REIT prices, and that’s really what we saw in 2022. It wasn’t that the businesses were doing poorly, we didn’t see massive amounts of tenants not paying their rent, we didn’t see a lot of vacancies, if anything, REITs business-wise did better than they had been. But it’s really a function of just the yield environment and what it does to income investments.
Deidre Woollard: Well, that’s a really good point. Another thing about REITs is the impact of interest rates in terms of trying to keep buying new properties. Looking forward, do you think that we’re going to see more mergers and acquisitions or more acquisitions in general? Is the cost of capital too high for REITs right now?
Matt Frankel: There’s actually a lot to unpack in the cost of capital. When you think about it, there’s two different ways that REITs generally fund their growth. Three, but the two main ways are by selling new shares, which I mentioned when yields rise, REIT prices go down, so it’s less desirable to sell shares and dilute shareholders to raise money that way. Or they can take on debt, which as you mentioned, is at a much higher interest rate. Growth becomes a little more difficult in this environment. The third way is using some of the cash flow that you’re not required to pay out as dividends in order to fund growth. That’s usually a minor way to fund growth for REITs.
REITs with a lot of cash on their balance sheets going into this are in very good shape. That’s where you’re starting to see a lot, and you’re starting to see a lot of private equity takeovers of REITs over the past year. Just some of our favorites, unfortunately, got taken out over the past year, American Campus Communities, STORE Capital is about to go private. These are going private because one, private equity investors or alternative asset managers are seeing a lot of demand for investments that aren’t stocks right now, which isn’t a big surprise because of what the market is doing, people are like, get me out of here, let’s get into something that’s a little more stable and predictable or at least that I don’t have to look at the price every day.
You’re seeing a lot of demand on the private equity side. You’re seeing a lot of take-private transactions. As far as mergers and acquisitions, I could see it coming back a little bit in 2023, a lot of REITs are very financially strong. REITs that have A credit ratings can still borrow relatively cheaply, but as far as just the flurry of M&A and the flurry of debt issuance and rapid growth that we saw over the past decade or so, actually, I’m expecting muted growth in 2023.
Deidre Woollard: When you say muted growth, what does that also mean for the dividends? Because that’s one thing that people are looking at with REITs. Obviously, you just talked about 2022 being not-so-great. Should we be looking for better dividend performance going forward?
Matt Frankel: Well, a lot of them raised their dividend significantly in 2020. Think of industrial REITs that are getting 30% more for the same leases than they were before the pandemic. They’ve passed some of that onto their shareholders. The general goal with REITs is you don’t think of it in terms of a year-to-year dividend increase, you want your income to grow over time. The general goal when I invest in a REIT is that I want to see its dividend rise at an annualized rate of 4%-5% over the long run. That’s what I aim for and I consider that to be strong dividend growth.
Remember, REITs have to pay out 90% of their taxable income, but there’s a lot more to that than a lot of investors realize. This doesn’t mean that if a REIT makes a dollar in profit per share, they have to pay out 90 cents of it. They have to pay out 90 cents of their taxable income, which can actually vary a lot from year to year. REITs have the tax deduction of depreciation, which in a lot of cases can chop their earnings in half for tax purposes, even though they’re making a lot more money. But with that in mind, REITs are still making money. But I’m expecting, I hate to use the word muted again, but muted dividend increases this year. Because of that high cost of capital, it’s putting a strain on growth.
If a REIT doesn’t have to give a 5% dividend increase, if they can keep their streak alive with a 2% increase and satisfy the requirements to remain a REIT by handing out at least 90% of its taxable income, from a REIT’s perspective, that’s a way to retain some of its earnings and reinvest that in growth instead of diluting shareholders by issuing new shares or taking on more debt or things like that. I’m expecting REITs to raise their dividends just enough this year to keep their dividend streak alive, but nothing like the 10% dividend increases that you’ve seen in some recent years.
Deidre Woollard: That makes sense. I like the way you framed that, how it’s a bit of a balancing act for REITs trying to keep all of those things equal and still deliver on what people expect, which is of course those steady dividend increases. I’m excited to talk about sectors with you, and especially I wanted to talk about office because I feel like you and I have had this conversation for so long and I love having it with you, but I want to take it in different direction this time. I want to talk about one of your favorite REITs, Empire State Realty Trust. For those of you who don’t know, this is one of Matt’s favorites. It owns the Empire State Building and a lot of other buildings, but it’s doing something interesting that other office REITs are also doing which is getting into other sectors. If office isn’t dead, but office is shifting, does it make sense for some of these bigger office REITs to look at differently, do they need to change up their property mix?
Matt Frankel: First of all, you hit the nail on the head with the office isn’t dead, but it’s different. You have to be a lot more selective than you used to. I would compare that to say the calls that the mall is dead five years ago. The mall wasn’t dead, people just wanted to go to the good malls. You saw Simon Property Group is doing off-the-charts well, which we’ll talk about later in the show. But the regional malls got hammered, even the decent quality regional malls got hammered. The same thing is starting to happen with offices. If there’s something special about an office property, be it the location, the history like the Empire State Building, you’re still seeing a lot of tenant demand for office space.
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