REITs are Red-Flagging Recession

But best in class property companies are well prepared.

“Fed watcher” talk has now decidedly shifted from interest rate increases to rate cuts. That in turn has greatly boosted expectations the US central bank and its global counterparts have indeed engineered a “soft landing,” meaning the long-feared recession is off the table.

Recessions have been exceedingly rare during presidential election years, which 2024 of course will be. Rather, the appointed Federal Reserve has tended to loosen up as the vote approaches to spur growth. The notable exception was 1980 when then Chairman Paul Volcker kept interest rates high and very likely doomed whatever chances then President Carter had for re-election.

It’s also true that, despite 21 months of rising interest rates, US economic data is still painting a fairly benign picture. But come down from 30,000 feet up and the picture looks a bit different.

That’s my top takeaway from Q3 results and guidance updates of the 86 real estate investment trusts in my The REIT Sheet coverage universe. Property owners have boots on the ground in literally every corner of the economy. And few signs show emerging weakness more clearly than waning ability/willingness of tenants to occupy their properties and stay current on rents.

To be sure, well-run REITs’ current challenges are still nowhere close to the magnitude of what they faced just three years ago. Nor are they likely to get there.

For one thing, it’s highly unlikely we’ll see mandatorily restricted usage of so many types of real estate for health and safety reasons, as we did in 2020-21 particularly for offices and shopping malls. And with that sector-wide catastrophe only just in the rear-view mirror, REIT managements have continued conservative operating and financial strategies, in stark contrast to pre-pandemic 2019 when so many were overextended.

Nonetheless, the verdict of my company-by-company analysis is crystal clear: REIT’s growth has slowed as 2023 has progressed. And that’s even true for sectors that have been consistently the strongest in recent years, including communications infrastructure and industrial trade/logistics.

The most obvious signs are slower year-over-year rates of growth for headline numbers like revenue, net operating income and funds from operations—with sequential growth from Q2 basically leveling off. And it extends below the top line to slower rent increases, reduced acquisition activity and lower occupancy rates, or slower gains in the case of grocery-anchored retail.

Only a handful of REIT management teams have to date issues their guidance for 2024. And there are encouraging signs already that management is ready for what’s to come next year. Life sciences facility landlord Alexandria REIT (NYSE: ARE), for example, projects 5.5 percent growth in FFO from the mid-points of guidance for 2023 and 2024.

But even for the best positioned REITs, the tone so far is generally cautious. And managements cite a variety of potential headwinds for that, including a still sub-optimal lending environment, questions about tenants’ ability to absorb higher rents with the cost of food and energy uncertain, regulatory issues at a time when the Administration in Washington is increasingly aggressive and the impact of inflation—especially higher labor costs—on overall expense levels.

The ability to sustain and especially to consistently raise dividends is one of the surest outward signs of inner grace for companies. Conversely, not raising and particularly cutting payouts is an unmistakable sign of business weakness, and all too often of more trouble ahead.

In 2022, the vast majority of REITs raised dividends. This year, however, just 34 of the 86 I track boosted their payout at least once in 2023, many at merely token levels of 1 percent or less. Another 43 did not raise dividends at all, or half the total I track. And nine REITs cut or eliminated payouts in the last 12 months.

Three of the cutters were financial REITs specializing mainly in buying and selling mortgages, a business rocked by volatile interest rates over the past 18 months. These companies continue to see deteriorating sector metrics such as declining book values and negative economic rates of return. And though most of the sector has rallied on expectations of falling interest rates, they face a potentially greater headwind in rising default rates as the economy weakens, especially those reliant on large office loans.

Most of the other REITs to cut this year did so because of exposure to office properties. This sector is still very much in an adjustment phase, as working from home induces tenants to downsize. And while Fed talk about cutting interest rates has triggered what’s pretty much an across-the-board rally, many of the leading names are still weakening on multiple business metrics—including SL Green (NYSE: SLG), which cut its dividend again this autumn.

Unfortunately, office and financial REITs were hardly the only property sectors that showed weakness or at least slowing growth in Q3. For example, even many stronger apartment and self-storage companies—both sectors that have historically been resilient during recessions—have been sacrificing at least some occupancy for the sake of reducing concessions on rents. And management has clearly communicated the expectation for more of the same in 2024.

The good news for REIT investors is —despite a powerful sector rally the past couple months—share prices are still generally well below where they were in early 2021. That reflects continuing fears of an unlikely repeat of the 2020 meltdown. And as companies continue to report what should be in-guidance results starting with Q4 early next year, those concerns should fade, pushing REIT prices to higher levels.

Ultimately, resurgent inflation should take real property of all types to new highs and well-run REITs along with it. That’s the consequence of lack of supply, made measurably worse by the Fed crunching investment the last 21 months with unaffordable borrowing costs. And it’s good reason for investors to build positions in the sector, particularly the best in class.

But weakening performance metrics for property companies in late 2023 are red-flagging softness in the economy. And it may be hard to see that from 30,000 feet in the air, where most economists operate.

That’s a good reason for investors to stay a bit cautious as we ring in another New Year and others prematurely celebrate a soft landing. Keep a bit of cash and stick to the best in class regardless of stock sector. That’s a reliable road to robust returns, whether we see a recession or not.

Merry Christmas and Happy Holidays everyone!