It isn’t news that real estate stocks have suffered over the last year and a half. The real estate market is susceptible to interest rate changes, and the Federal Reserve has jacked up rates rapidly during that period. Valuations fell as a result, and investors continue to avoid REITs and other tangible estate-based assets.
Investing in REITs will return to fashion again. That’s certain. Everything is cyclical, meaning investors must pay attention to signals at all points. Fortunately for those interested in REITs, the signals grow increasingly favorable. Let’s dive deeper into those signals because they suggest gains ahead shortly.
The worst is over, as rate hikes appear to stall
That’s right; there’s a reasonable case to be made that the worst appears to be over for the real estate sector. REITs closely follow the trajectory of the real estate sector, and both are sensitive to rate hikes.
Of course, the markets seem to be signaling that investors believe the Fed’s rate hikes could be over. More and more financial experts echo that sentiment after the Fed’s recent decision to leave interest rates unchanged.
If the current Fed funds rate between 5.25-5.5% is as high as it will go, then REITs will soon heat up in price.
That doesn’t mean investors should blindly rush out and purchase any and every undervalued REIT. Investors must still consider other factors outside of rates that have lowered their levels. That includes factors like business risk and geographic risk. Geographic risk has been a particularly tricky factor to understand. Generally, though, investors should remain cautious of expensive areas that have suffered exodus over the past few years.
REIT financial figures aren’t as bad as you might have been led to believe
I’d assume that many investors believe capital costs are currently above 5% for REITs. Current lending is much more expensive and is subject to Fed rate increases. However, REITs, like all businesses, carry a variety of debt with differing maturity dates. A while ago, the weighted average cost of capital across REITs stood at 3.3% with a 7-year maturity. It now stands at 3.7%.
Further, leverage ratios at 34% currently are not high. Ratios below 50% are considered healthy in general. That 34% figure implies that REITs have not had to take on large amounts of debt to continue to operate. Thus, they haven’t created debt servicing liabilities that would serve as a drag on their businesses.
Again, caveat emptor applies here. That 34% figure is an average that applies to all REITs. Before investing in a given REIT, doing your due diligence and running the numbers makes sense.
The worst may be over, and dividends are very high
Investors continue to understand that the worst may be over in this business cycle. Yet, at the same time, REIT prices remain depressed.
REITs generally pay higher dividends due to favorable tax structures and other factors. That’s true even when share prices are firm. REITs provide high yields. When share prices fall, as they have, and dividends go unchanged, yields rise even higher.
Thus, the investor who picks up shares today effectively locks in a higher-yield dividend, assuming there are no changes to its payment.
Lastly, REITs are expected to shift from selling to buying mode soon. REITs have had to sell off assets due to their declining value recently. Cohen & Sheers and other real estate research firms believe that a shift will occur soon, and REITs will move from net sellers to net buyers of assets. They should be able to pick up inexpensive holdings at the bottom, which could yield significant value as cycles strengthen in their favor.
On the date of publication, Alex Sirois did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
