REITs might be right for advisors searching for yield, earnings growth

Steve Brown of American Century Investments

Office may have issues, but other property sectors have pricing power and can raise rents greater than inflation.

It’s not strange that commercial real estate worries continue to keep advisors and investors from loving REIT stocks. Still, maybe it’s finally time they stop worrying and love the bond alternatives.

Real estate investment trusts have not exactly sprinted out of the gate in 2024. The iShares US Real Estate ETF (IYR) is down close to 3 percent, compared to a surge of almost 8 percent in the S&P 500 index.

A lot of that underperformance stems from the nearly empty buildings in plain sight in major cities from sea to shining sea. The national office vacancy rate rose to a record-high 20 percent in the fourth quarter, according to Moody’s Analytics. The average office vacancy rate before the pandemic was just under 17 percent.

Also not helping REITs was the step-up in bond yields last year, as the benchmark 10-year Treasury flirted with 5 percent before finishing the year around 4 percent, where it currently stands. That compares to 2.8 percent for the IYR, but without the risk of so-called “jingle mail.”

That said, Treasury bonds don’t have earnings growth to help propel their shares higher. And Steve Brown, senior portfolio manager at American Century Investments, expects earnings growth in the sector to be about 4 percent in 2024.

“The REIT industry is very diversified among different sectors like data centers, towers and industrial. And office is only about 4 or 5 percent of the index,” Brown said. “So while office has issues, many other property sectors have pricing power and can raise rents greater than inflation.”

Among the real estate sectors he sees having pricing power are data centers, industrial retail, senior housing and hotels. And while the ability to charge more for a night or month’s stay is important, so are those three old rules of real estate investing: location, location and location.

“The data centers are doing well everywhere in the country, whether it’s Virginia, New Jersey, or Texas, because of the big demand. I would also say that industrial and hotels are pretty strong throughout the country,” Brown said. “But if we were looking at real strength, I think the Metro New York area is still quite strong because of good job growth and limited supply in many of the different property sectors.”

Even those empty offices are beginning to fill up, he says.

“If a year and a half ago people were coming into the office three days a week, today they’re up to four,” Brown said. “Is it going to go to five? I don’t necessarily think so, but office utilization has improved.”

More importantly, unemployment remains low in the United States, which is good for offices in need of workers to fill them. Furthermore, interest rates could be heading lower by year-end once the Federal Reserve starts its rate-cutting program, dulling the appeal of government bonds.

“We think that if the Fed’s done raising rates in 2024 and if the 10-year stabilizes at around 4 to 4¼ [percent], that should serve as a decent tailwind for stock performance,” said Brown, who identifies Equinix, Digital Realty and Welltower as his top picks in the sector.

When it comes to the choice between public and private REITs, which have been all the rage in recent years, Brown says the publicly traded version is not just more liquid given the benefit of daily pricing, but cheaper as well.

“The private REITs really haven’t marked down their books the way they should because they only price their shares once a month,” said Brown. “So while public rates are at a 20 percent discount to net asset value, we think the private REITs are a little bit above NAV, so public rates are much cheaper.”