Will Real Estate Survive a Banking Crisis?

If so, top quality, high quality real estate investment trusts are cheap!

Count me skeptical that banking system turmoil is done for the year.

The Federal Reserve raised its benchmark Fed Funds rate by only a quarter point. But any boost just days after several major bank failures is a clear sign the central bank will keep squeezing the economy to quell inflation. And more than a few highly leveraged banks are on the brink of succumbing to the pressures of fleeing depositors, uncollectible debts and plunging fixed income asset values.

By raising the cost of money, the Fed and US Treasury are committing to a “whack a mole” strategy—propping up institutions where failure is deemed to present substantial systemic risk. Bailing out SVB’s large depositors, for example, was considered key to avoiding a venture capital meltdown.

Fed Funds futures, however, are now pricing in deep cuts later this year. That’s a sure sign investors believe the Fed’s approach will fail--and that it will be forced to abandon efforts to bring down inflation. And it’s why gold prices have again broken above $2,000 an ounce.

When there is more banking turmoil, stocks will head lower with few if any sectors unscathed. That likely includes real estate investment trusts. REITs today offer investors a way to own everything from data centers to farmland in a tax advantage way, and they trade like common stocks.

After a weak 2022, REITs got off to a good start this year. But they’ve faded since, particularly as banking sector turmoil has picked up steam. Momentum is clearly broken. And some sectors like office properties and mortgage/financial REITs have been free-falling.

With a couple of exceptions, I’ve been negative on office properties and mortgage REITS for some time. Office properties are adjusting to the post-pandemic reality that working from home is here to stay in most industries. Large and mid-sized corporations, government entities and others will need to lease space. But when leases expire, they’re going to rent less and demand lower rates.

As for mortgage REITs, Annaly Capital Management (NYSE: NLY) cut its quarterly payout by -26 percent this month. Rising interest rates have simultaneously cut the value of its mortgage assets and raised cost of capital, forcing management to retrench.

Banks are primary lenders as well as owners of real estate. And too many made the bet that the Fed would succeed in quelling inflation last year. They invested in long-term debt including US Treasurys. Now they’re stuck with mounting losses.

History suggests banks’ demise could trigger severe fallout for at least some REITs.

Following the collapse of Lehman Brothers in late 2008, for example, the S&P REIT Index dropped almost -50 percent before bottoming. Dividend cuts in the sector were rampant, even for industry leaders like trade-focused industrial REIT Prologis Inc (NYSE: PLD). And while that REIT now pays a dividend 67 percent higher than the pre-2008 cut rate, it took 15 years to get there.

More than a few REITs with weak fundamentals didn’t survive the 2008 Financial Crisis. And you can count on one hand the number of mortgage REITs that made it through.

I believe a repeat of 2008 REIT carnage is unlikely for two main reasons. First, the sector is fresh off one of its worst years ever in 2022. As a result, measures of standard valuation are relatively low even for long-time Wall Street favorites.

Prologis’ share price, for example, is one-third less than it was last spring. And it yields twice what it did at the beginning of 2022, after a recent 10.1 percent dividend increase. Other blue chip REITs are also no longer expensive, like telecom equipment owner American Tower (NYSE: AMT), residential franchise Mid-America Apartment Communities (NYSE: MAA) and retail mall Simon Properties (NYSE: SPG).

That contrasts strongly with the situation just prior to the 2008 Financial Crisis, as REITs did not drop until Lehman Brothers collapsed. Also, REITs in 2008 had seen little business hardship for years in a US economy that was never too hot or too cold. Many were very leveraged to the good times continuing, and therefore were wholly unprepared when everything suddenly came unglued.

This time around, REITs are barely two years removed from what was an existential crisis for many. That’s 2020 pandemic restrictions on occupying physical space.

It’s highly unlikely anything we’ll see by way of recession this time around will be worse for REITs then hit by rapidly rising vacancies, falling rents, plunging collection rates and surging tenant bankruptcies. Moreover, there simply hasn’t been time for even the most aggressive REITs to really lever up. Most have stayed quite conservative with their financial and operating policies.

Simon Properties, for example, shut its enclosed shopping malls across the US and slashed its dividend in 2020. But management has since strengthened its balance sheet and while shoring up its tenant base. Simon’s conservatism resulted in strong Q4 results and guidance. And it’s well positioned to gain further on rivals in a downturn.

That’s also the case for other best in class REITs that survived 2020 and have since demonstrated positive business momentum. And it’s reflected in strong dividend growth we’ve seen this year, including 10 percent plus dividend growth at Mid-America, Prologis and others.

There’s no better outward sign of inner grace than a growing dividend. So long as companies stay solid on the inside, they’ll weather the turmoil in the broader environment. And few asset classes can boast REITs’ track record of beating inflation long term.

The worse things become for the banks, the more likely it is even the best REITs haven’t see their final lows. That’s why I recommend taking an incremental approach to investing in them: Buying one-third of your intended investment now, one-third in 4 to 6 weeks after Q1 earnings results and guidance updates—and the last third this summer.

My REIT Sheet features coverage of 85 leading sector companies. But whether you pick the best individual companies or are OK focusing on average with REIT ETFs, this is one sector set to turn the rare feat of producing high and rising income as well as capital in the decade ahead—even as inflation steadily eats away at the majority of savers and investors.