2023-04-29 13:00:00 ET
Summary
- Rising interest rates and inflation have left the share prices of REITs quite battered.
- With the Fed slowing on rate hikes, and peak interest rates likely behind us, this will be a big tailwind for Property REITs.
- The prices are at bargain levels, offering a unique buying opportunity.
- Here are two great REITs with yields up to 8% to buy the dip and boost your income!
Co-authored with PendragonY.
REITs Have Crashed
Real Estate Investment Trusts (REITs) have seen significant share price declines for more than a year.
The $32 billion Vanguard Real Estate Index Fund ETF Shares ( VNQ ) returned minus 26% last year, including dividends, as income-generating assets, in general, faced significant headwinds on share prices. The main reason was the Federal Reserve's very aggressive rate-tightening to curb inflation. The share price decline wasn't unexpected.
REIT returns are a little better this year compared to 2021. VNQ is down about 0.2% year-to-date. While it remains unclear just how much the Fed will still hike in the near future, the markets are already pricing in an interest rate peak. In our opinion, Mr. Market is right. The Fed will have to start cutting rates in 2024 in order to avoid a recession. Reducing interest rates will be key for a soft landing, which is the Fed's objective.
Also worrisome for REIT investors are the problems of regional banks , a big source of commercial real estate loans. A pullback in lending could be devastating for the property markets. However, most REITs took steps after the Great Financial Crisis so that they can weather periods of tight credit conditions.
Everything hasn't been all gloom and doom for REITs recently. While the sector as a whole is slightly positive for the year, some subsectors have done quite well. For instance, industrial REITs, whose holdings include warehouses used by shippers, have, on average, returned nearly 8% year-to-date. Also single-family home REITs, despite a pullback in housing prices, have produced 6% returns year-to-date.
On the other hand, the office sector, which has seen profound changes in working arrangements triggered by the pandemic, is down 17% this year. While this sector will eventually adjust to the new economic conditions, this is likely a long way off.
VNQ hit its most recent peak around the start of 2022, and it has been mostly downhill from there. Last fall there was a short-lived recovery in price, but VNQ recently hit prices near its 52-week low. Today, while it is off that low, it remains close to its 52-week lows, creating unique buying opportunities in some very solid names.
As income investors, it is worth noting that despite the decline in share price, the dividends paid by VNQ went up in 2022 compared to 2021. The fund paid out $3.2261 in 2022, up from $2.9656 in 2021. This is a staggering increase of 8.7%! This gives us an idea that many REITs have been unfairly punished, with some individual REITs doing extremely well.
So, much like the old Timex watches, while REITs took a beating last year, they kept on ticking.
We are nearing the end of the interest rate increase cycle. Historically, this has been the best time to start buying REITs. With prices having bounced off of 52-week lows, this now provides us with a buy signal. So where should an income investor look for opportunities in REITs today?
Opportunity #1: Realty Income - 4.9% Yield
Realty Income Corporation ( O ) proved again in 2022 that it is the Dividend King of REITs by hiking its monthly dividend each and every quarter. Those dividend hikes in 2022 totaled an amazing 7.1% increase for the year, hiking it to $2.969 in 2022 compared to $2.7706 in 2021, even after the spinoff of Orion Office REIT Inc. ( ONL ).
Already this year, Realty Income has increased the dividend twice, and the current yield is at 4.9%, with more to come!
The price chart below shows that O's price, like the rest of the REITs, has taken a significant hit. While it has recovered some, it is still well below its average price in 2022 and some 16% below its 52-week high price.
Let's look at how well-supported the dividend is. AFFO (Adjusted Funds from Operation) is the best metric for judging REIT dividend coverage. Based on data presented for the Q4 earnings report , we can see that the company has done very well over the years, continuing to grow AFFO/share at a long-term CAGR in the 5%s. Keeping pace with its dividend hikes.
Realty Income - Investor Presentation Feb. 2023 Realty Income - Investor Presentation Feb. 2023
Having issued two bonds totaling $1.1 billion with an average coupon of around 5%, plus another $1 billion in a multicurrency deal, Realty Income is well positioned to have the cash to grow further, even if we hit a mild recession. In fact, a recession would offer this REIT the opportunity to pick up new assets at bargain prices.
With an increase in AFFO per share at a rate of +9% in 2022, plus $5 billion in planned acquisitions and two dividend hikes in 2023, O is a great opportunity. Buy now while its share price is still close to its 52-week lows!
Realty Income reports Q1 earnings on May 3rd after the market close.
Opportunity #2: RQI - 8.3% Yield
Cohen & Steers Quality Income Realty Fund ( RQI ) is a closed-end fund, or CEF, that gives the investor instant diversification in the Property REIT sector which is battered today. As a result, RQI currently trades at a very attractive price. The price just bounced off of its 52-week low of $10.78, the current price is just 7% higher, and remains well below the 52-week average. With NAV around $12.34, the price is also at a modest discount to NAV. The 8 cents monthly distribution has held steady since October of 2016, when RQI switched from a quarterly to a monthly distribution. Last year's special distribution (extra distribution on top of the regular monthly distribution) of $0.237 a share is evidence that the fund did well in 2022. The distribution also contained no ROC in 2022 or so far this year.
Note that by buying a CEF, investors benefit from professional management and research in addition to active management. This is unlike property REIT ETFs such as VNQ which are not actively managed, but rather follow an index, which often results in under-performance. Also given the much larger yield of RQI compared to VNQ (8.3% versus 4.2%) and the 30% leverage used by RQI, it is clear that RQI did better than average at managing its portfolio during the very tough year of 2022.
RQI also has very low exposure to office properties and good exposure to industrial properties. The Top 10 (other than maybe Simon Property Group (SPG), although it is the best of the mall REITs) are all REITS that have great potential.
CEFdata website
With its solid distribution and good exposure to desirable sectors, RQI can expect that the market price of its holdings will continue to increase as the markets price-in a peak in interest rates, and probable interest rate cuts in the coming years. The 30% leverage the fund uses will magnify that upside. And it should have little or no trouble covering the distribution as the headwinds in the REIT sector subside. The current price is a very good entry point for this fund.
Conclusion
REITs tend to take big hits on share prices when interest rates increase. We saw that last year and the sector has not recovered much since. However, well-managed REITs see a much smaller impact on their earnings. They are able to manage their balance sheet prudently while benefiting from the inflation that caused rate hikes in the first place.
With the Fed likely nearing an end to the hiking cycle, REITs are set to see the headwinds on share prices dissipate. With share prices near their 52-week low, now is a good time to buy more shares. At High Dividend Opportunities, we have good exposure to Property REITs as part of our model portfolio, which currently yields +9%. Exposure to great property REITs like O and solid REIT CEFs like RQI is highly recommended in every portfolio, especially retirement portfolios.
Today, O and RQI offer a great yield with high upside potential. O offers a steadily growing dividend, while RQI offers diversification, professionally managed leverage, and research. I am taking this opportunity and buying the dip in REITs with big dividends!
For further details see:
Alert: REITs Have Tumbled, 2 Great Opportunities