Why Stock Investors Should Take a Closer Look at REITs
Many investors overlook Real Estate Investment Trusts (REITs), assuming that direct property ownership or exposure through diversified equity funds already provides enough real estate in their portfolios. Yet, the current market landscape makes a fresh look at REITs worthwhile, especially for those seeking value opportunities after a challenging period for the sector.
Interest rates have posed a substantial headwind for REITs over the past five years, with both U.S. and global real estate lagging behind other sectors. While the U.S. Federal Reserve's rate hikes have helped lift bond yields, they have undermined REITs by making fixed income more attractive and increasing borrowing costs for property managers. As a result, funds have been flowing out of real estate-focused mutual funds and ETFs. Despite this tough environment, there are signs of contrarian value for long-term investors. The Morningstar Global Markets ex-US REIT Index, for instance, has bounced back this year, partly due to a weaker dollar. And although the U.S. REIT Index hasn’t outperformed, it has proven comparatively resilient during certain market sell-offs and now trades roughly in line with the broader equity market.
Yield remains a major draw for REITs. At the end of May, the Morningstar US REIT Index was producing a dividend yield of 3.8%, and the Global Markets ex-US REIT Index yielded 5.3%—both higher than the equity market averages. However, these yields are now somewhat less competitive, as U.S. core bond yields have risen to nearly 4.7%, with less risk than equities. This means that REITs must appeal to investors for reasons beyond just income.
Portfolio construction is one such reason. REITs offer several advantages over direct property ownership: they eliminate the hassle of maintenance, provide tax benefits, and reduce idiosyncratic risk by pooling diverse types of properties across different locations. Historically, REITs also contributed diversification benefits to equity portfolios, behaving differently than the broad stock market in certain periods. However, over the past five years, correlation between REITs and the broader equity market has increased, limiting their diversification power. For context, the Morningstar US REIT Index showed a five-year correlation of 0.83 with the U.S. equity market, much higher than sectors like energy.
Another consideration is inflation protection. Real estate is often seen as a hedge, since rents and property values tend to rise with inflation. But, for REITs, inflation also means higher operating and construction costs, which can hit earnings before the potential benefits of rising rents materialize. In addition, the segment faces structural challenges from remote work, e-commerce, and disruptions to retail and hospitality. Not all REITs are equally vulnerable, though—data centers, cell tower operators, and healthcare-focused REITs may benefit from secular trends like AI adoption and an aging population.
Despite recent underperformance and concerns over higher rates, many REITs currently trade at significant discounts to their historical valuations. Value investors may find opportunity here, especially in out-of-favor names where share prices appear to have overreacted relative to fundamentals. For those interested in the sector, both direct REIT stock picks and diversified ETFs can offer exposure.
In sum, while the days of outsized REIT diversification and yield advantages may be tempered for now, the asset class deserves renewed consideration. For investors looking past the noise of recent losses and toward long-term portfolio construction, today’s REIT landscape may provide both value and unique opportunities as market trends evolve.