REITs are Running: Should You Buy?

Yes, but don’t chase the leaders.

After two and a half years of “higher for longer,” the Federal Reserve cut interest rates last week. And with the stock market largely not reacting, the 50 basis point reduction in the benchmark Fed Funds rate is clearly what most traders were betting on.

The Fed’s long-awaited pivot is very good news for real estate investment trusts or “REITs.” Higher interest rates diminished REITs’ appeal by pushing up money market yields. Worst, they cut deeply into growth by stalling the pace of deal-making, raising the cost of new development, jacking up debt interest expense and making it more difficult for many tenants to pay rent.

From the beginning of 2022 through October 31, 2023, the S&P Real Estate Sector Index lost roughly one-third of its value. And excluding gains in a handful of unconventional REIT sectors—for example data centers—investor losses were much, much worse.

Companies with exposure to office buildings, commercial loans and hospitals were especially mauled. And as is always the case in downturns, landlords loaded with the most debt when rate started rising paid the highest price.

Lower interest rates are the surest cure for what ails REITs. In fact, since the beginning of November last year, the S&P Real Estate Index is up almost 40 percent. And after a powerful rally starting in early July, the Index is ahead more than 13 percent for the year to date.

REITs’ recovery began last year when inflation seemed to moderate, making further Fed rate increases less likely. It stalled when inflation gauges moved higher in early 2024, temporarily throwing cold water on expectations of rate cuts. And the sector surged again this summer, as probability of a rate cut reached 100%.

The S&P REIT index is actually slightly underwater since Wednesday when the Fed took action. One likely reason is comments by Chairman Powell to the effect that investors should not assume cuts of equal magnitude going forward.

But for the property sector, what’s been a very powerful headwind to business since early 2022 is now in process of becoming a tailwind. And that’s very bullish for earnings, dividend growth and eventually REITs’ stock prices.

What investors should not automatically expect is (1) an immediate panacea for the ongoing woes of weaker REITs or (2) near-term upside for stocks. And while there’s still a number of high quality REITs trading at discounted prices, some of the more popular names are actually candidates for partials sale to lock in windfall gains.

For example, about a month ago, I posted “What’s Behind Rising Rents,” highlighting inevitability of a Fed rate cut—but also the buying opportunity many were missing in apartment REITs, which were absorbing new supply much faster than most analysts and economists had projected.

At the time, the two leaders I highlighted—AvalonBay Communities (NYSE: AVB) and Mid-America Apartment Communities (NYSE: AVB)—were already showing fat gains for 2024. And since then both have surged further. AvalonBay last week actually hit a point where investors should take a little money off the table.

Bottom line: The medium-term picture for REITs—the next 18 to 24 months—has turned quite positive. But the near-term is considerably cloudier, in large part because sector stock prices have risen quite far and fast.

First, the benefit of interest falling rates will be progressive, rather than precipitous. That’s true both from the standpoint of an eventual drop in money market yields and from improving business conditions.

Borrowing rates for investment grade REITs, for example, have already come down quite a bit the past 10 months. The yield to maturity for BBB-rated BXP Inc (NYSE: BXP)—formerly Boston Properties—bonds of January 2034 has dropped from almost 8 percent in late October to less then 5.4% this week.

That’s a huge positive for this REIT, whose past couple years earnings were depressed by higher financing costs to shift to “premium” office properties. Premium buildings, which typically command occupancy 5 to 10 percentage points above conventional office, are just 6.5% of the total US market now.

But they’re nearly 90% of Boston Properties’ portfolio and rising. And with the REIT’s interest costs now dropping, the benefit is showing up in earnings and guidance, which management increased last month.

On the other hand, deep junk B- rated Medical Properties Trust (NYSE: MPW) cut its dividend by another 47% earlier this month. Management blamed the cost of a “global” settlement with a defaulted tenant, the bankrupt Steward Health Care. But with other hospital tenants also teetering, the subtext is the REIT still needs to cut debt fast and will sell major assets to get there.

Lower interest rates should help Medical Properties by making it easier to sell, and potentially refinance the $1.477 billion in debt that matures next year. But management still has a lot of work to do.

Second, REITs’ stock prices are still exposed to risks in the broad economy and stock market. The two previous times the Federal Reserve led off a pivot with a 50 basis point rate cut, for example, were 2001 and 2007—just prior to recessions for which the central bank was arguably behind the curve.

Market history rarely if ever repeats exactly. But as author Samuel Clemens/Mark Twain once famously said “it often rhymes.”

If you follow REITs as I do, it’s hard not to notice points of weakness—hospital defaults for example—that others observing the action from 30,000 feet up may overlook. And it’s not hard to imagine worsening, especially with the world’s second largest economy China underperforming.

The other factor that should be worrying a lot more people is just six very expensive Big Tech stocks are almost 30% of the S&P 500. And that index and related ETFs have arguably never been more important to Americans’ overall wealth, with more money for the first time passively invested in stocks than actively managed.

These six stocks have grown big enough to not only bring down the entire stock market but very likely the economy too. And it’s hard to imagine REITs dodging all the damage, especially the stocks that have run the most.

High quality REITs are ripe for the picking. But shop selectively, deliberately and with an eye on prices!