$Realty Income(O)$ $Prologis(PLD)$ $WELLTOWER OP LLC(WELL)$ $American Tower(AMT)$ $Public Storage(PSA)$
As we all know, REITs have been struggling significantly in the market recently. Over the past couple of months, the S&P 500 U.S. REIT Index has dropped roughly 12%, which is quite disappointing given the strong performance REITs experienced between April and November of last year. This downward trend has affected every REIT sector, including data centers, retail, industrial, and others. As we move into 2025, the outlook remains challenging for this dividend-rich sector.
In this discussion, we’ll explore why REITs are facing such difficulties and what the future might hold. To start, let's compare real estate to other major sectors in the market. Sector SPDR ETFs, a company managing 11 sector-specific funds, provides valuable insights. Their funds cover sectors like utilities, technology, healthcare, and real estate. Using their sector tracker, we can see that real estate has been the second-worst performing sector in the stock market over the past year, narrowly outperforming healthcare but lagging behind sectors like materials, consumer staples, and utilities.
This significant underperformance isn’t isolated to REITs—it reflects a broader downturn across the entire real estate sector. Homebuilders like PulteGroup, Toll Brothers, and Meritage Homes have struggled since November, and the downturn extends to real estate services, including brokerage and transaction management companies. Mortgage REITs, which invest in or issue mortgages, have faced even tougher conditions. For example, the iShares Mortgage REIT ETF (REM) has fallen more than 50% over the past five years.
What makes this situation more perplexing is that recent economic news has been relatively positive. Consumer goods prices are cooling, and the Consumer Price Index has slowed. However, despite this good news, REITs and the broader real estate sector remain under pressure.
The primary reason for this continued struggle is market pessimism regarding interest rates. Inflation remains persistently high, and the Federal Reserve has signaled a less aggressive approach to cutting interest rates than previously anticipated. This is particularly challenging for the real estate sector, which is highly sensitive to interest rates. REITs, in particular, are affected because their growth relies heavily on borrowing to expand their property portfolios.
Real estate is a cyclical industry that experiences periods of under performance and out performance based on economic conditions. Currently, the inverse relationship between interest rates and REIT performance is weighing heavily on the sector, making it more vulnerable compared to other industries.
REITs have the option to raise capital by issuing new shares of their stock, a strategy many companies use regularly. However, this approach is more advantageous when share prices are high, as it minimizes dilution. When interest rates rise, borrowing becomes more expensive, making property acquisitions less profitable. Consequently, many REITs slow their expansion during periods of high interest rates. Instead, some rely more heavily on issuing new shares, which, while less costly than debt financing, ultimately dilutes shareholders' equity and puts downward pressure on share prices.
High interest rates also impact the tenants occupying REIT properties, increasing operational pressures. This has been particularly severe in certain sectors, such as office REITs, which have faced significant challenges in recent years. Despite these difficulties, many REITs continue to report strong financial performance, as we’ll explore shortly. However, the market remains pessimistic about the sector's prospects, especially with the Federal Reserve indicating a more cautious approach to rate cuts in 2025.
This pessimism is compounded by broader economic dynamics. For instance, while Donald Trump has called for significant rate cuts, borrowing costs depend on various factors beyond the Fed's policies. This complexity is evident in the mortgage market, where 30-year mortgage rates recently exceeded 7%, despite rate cuts by the Federal Reserve.
Certain REIT segments, such as retail, have also faced increased pressure due to tenant bankruptcies. Notable store closures have impacted retail REITs, which lease space to these tenants, adding another layer of difficulty that requires ongoing monitoring.
Given the prolonged period of high interest rates and the market's unfavorable sentiment, how have REITs been performing? As of their latest reports, key dividend payout ratios for REIT Dividend Aristocrats remain within conservative ranges. For example, Realty Income has a payout ratio of 75.4% (based on AFFO), Federal Realty Trust is at 64.3%, and National Retail Properties (Triple N) is at 69%. Since a payout ratio between 70% and 80% is generally considered safe for REITs, these figures indicate financial stability among leading REITs.
Notably, over the past two to three months, only one REIT out of over 225 publicly traded companies has announced a dividend cut: Service Properties Trust, a small hotel REIT that has faced ongoing challenges. This suggests that most REITs remain resilient, even in tough market conditions.
Ultimately, the primary reason REITs have been under performing is the market's lack of optimism about interest rate cuts. Active investors and financial institutions have shifted their focus toward higher-performing sectors, leaving REITs out of favor. Price movements in the market are often driven by these trends, and with interest rates remaining high, many investors are opting to avoid REITs for now.
The great news is that if you’re not a day trader or financial institution and instead focus on generating passive income through dividends, REITs currently present an excellent opportunity. Many companies in this sector are offering exceptional dividend yields that are significantly higher than usual. For example, Realty Income and National Retail Properties (Triple N REIT) are offering yields close to 6%, compared to their typical range of 3-4%. This means you’re getting much more value for your investment.
Keep in mind that while REITs may not yield as much as some other investment classes in the short term, they excel at long-term dividend growth. Unlike closed-end funds and covered call funds, REITs have a proven track record of consistent dividend increases over time. For those who prefer high-yield investments, such as covered call funds or business development companies, it’s still crucial to include assets in your portfolio that provide steady dividend growth for the long term.
If you’re a long-term investor—which is the approach I always encourage—now is a great time to invest in these discounted stocks. Despite the challenges posed by higher interest rates, many REITs are continuing to grow. Over time, their share prices are likely to align with their increased size and value. If your goal is to live off dividends, focus less on share price fluctuations and more on dividend payout ratios, which remain strong for most REITs.
Better times are ahead—they always are—and right now is an excellent opportunity to buy discounted REITs and boost your dividend income. With that, we’ll wrap up today’s discussion.
Disclaimer: I want to make it clear that I am not a financial advisor, and nothing I say is intended to be a recommendation to buy or sell any financial instrument. Additionally, it's important to remember that there are no guarantees or certainties in trading or investing, and you should never invest money that you can't afford to lose.
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