Investing in real estate hasn’t been easy of late. Real estate investment trusts have been beaten up more than the overall stock market this year. While the S & P 500 slid 21% year to date, REITs plunged 30%, per the MSCI US REIT Index . The index, which has 132 constituents, represents about 99% of the U.S. REIT universe. Last year, the MSCI US REIT Index gained 42%, compared to the S & P’s increase of nearly 27%. Their underperformance this year can be pinned to rising interest rates, since investors who have REITS for their high dividend yields may dump the assets for risk-free Treasurys. Those Treasury yields have been climbing this year, with the 10-year yield at one point topping 4% last week. On top of that, while REITS have been historically known as hedges against inflation, that isn’t the case this time around, according to a recent Morningstar report. The assets won’t immediately feel the benefit of higher inflation and might even see negative effects due to several reasons, including the fact that many sectors won’t be able to react with rent increases due to long-term leases, Morningstar senior equity analyst Kevin Brown wrote in the report. Inflation also drives up operator costs, the price of building materials and labor costs, he pointed out. In addition, the REIT market has significantly changed over the years. As a result, REITS are generally undervalued, Brown said. “The long-term fundamentals for the sector are still healthy and strong and that should support growth of the stocks over the next three years,” he told CNBC. How should you invest in REITS? There are several things to take into account when deciding whether to invest in REITs and what to buy. For one, REITs should be an intermediate- to long-term investment. They should also be part of an overall diversified portfolio. “To determine the amount of your portfolio that should be allocated to alternate investments such as REITs, keep in mind your time horizon, your income needs, the tax efficiency of your portfolio and, of course, what is the end play,” advised certified financial planner Omar Morillo, founder and senior wealth advisor at Imperio Wealth Advisors in Miramar, Florida. Keep an eye on the path of the Federal Reserve ‘s continued interest rate hikes , which is impacting Treasury yields, said CFP Chuck Failla founder and CEO of Sovereign Financial Group in Stamford, Connecticut. Names that are more sensitive to higher rates will likely continue to underperform until those yields come down. However, Failla is now looking to get ahead of the Fed. While he had reduced his firm’s exposure to REITs due to rising interest rate fears, he’s now thinking about increasing that exposure. REITs typically make up 5% to 10% of his firm’s 10-year plus portfolio portfolio, with the exposure currently at the lower end of that range. Another factor to consider is performance — to a degree. “Performance is a starting point,” Failla said. “I’m looking for performance that makes sense: What I would expect it to do in various market conditions, more so than outperformance.” If you buy those that have their great fundamentals already priced in, you’ll be getting in at the peak, Morningstar’s Brown added. “You have to identify the undervalued sectors, whose short-term issues should get resolved over the long term,” he said. Sectors in focus Think strategically when focusing on specific sectors within the REIT market. For instance, REITs that hold office buildings may not be the best idea right now, as office occupancy rates remain low due to hybrid and remote work. New York City commercial office buildings saw a 45% decline in values in 2020 and 39% in the longer-run, with the latter representing $453 billion in value destruction, according to a National Bureau of Economic Research paper titled ” Work From Home and the Office Real Estate Apocalypse .” As of late September an average 47.2% of offices in 10 cities were occupied , according to Kastle’s Back to Work Barometer. Yet, there are some REITs that are poised to do well, experts said. In this environment, companies that are less sensitive to rising interest rates should outperform, said Morningstar’s Brown. His top pick is Simon Property Group , because its long-term leases help insulate it from any immediate negative impact of an economic slowdown. The company also has a strong balance sheet and significant free cash flow, he said. Hotels REITS are another good investment, particularly because they have years of revenue growth recovery ahead, Brown said. They’ll benefit from inflation in the short term because they can immediately raise room rates, he noted. “They should be less sensitive overall to interest rates movements given that most investors are not in hotel names for the dividend,” Brown said. Investors just need to be aware that if there is a recession, that will slow down their recovery. Brown specifically likes Park Hotels & Resorts and Pebblebrook Hotel Trust . Meanwhile, solid fundamentals and positive long-term trends, like an aging Baby Boom population, should provide an advantage to the health-care sector, said Imperio Wealth Advisors’ Morillo. Hospitals, medical offices and long-term care facilities are within that space. “People still get sick and they still need health care no matter what happens in the economy,” he said. Brown also believes the health-care sector should do well thanks to its solid fundamentals, although he cautions it will likely continue to underperform during the rising rate environment. He likes Ventas , which has exposure to senior housing. The population of people aged 65 and older was 54.1 million in 2019 and is projected to reach 80.8 million by 2040 and 94.7 million by 2060, according to the Administration for Community Living . All but a tiny percentage live in non-institutional settings, the organization said on its website. Other sectors that look interesting are multi-family housing and self-storage units, as well as warehouses, as retail continues to move towards fast shipping to customers, Failla said.
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