Real estate investment trusts (REITs), companies that own and operate income-producing real estate, are poised for a resurgence after a period of underperformance relative to the broader stock market. This lag creates a compelling investment opportunity, particularly for income-seeking investors, as REITs currently offer attractive valuations and the potential for significant dividend yields. Closed-end funds (CEFs) specializing in REITs provide an even more attractive entry point, offering enhanced yields and potential for capital appreciation.
The underperformance of REITs over the past five years, compared to the robust returns of the S&P 500, is atypical. Historically, REITs have often outpaced the broader market. This divergence is even more peculiar given the current relationship between REIT prices and housing prices. While housing prices have experienced substantial gains over the past decade, exceeding their long-term average growth rate, REIT prices have lagged, suggesting a disconnect between the two. This discrepancy can be attributed to market anticipation of a potential correction in the housing market, fueled by elevated mortgage rates and affordability concerns. This pessimism towards the housing market has spilled over to REITs, creating an undervaluation scenario.
The current market sentiment surrounding REITs presents a unique buying opportunity. REIT prices are currently lower than both during the housing bubble of 2007 and the subsequent recovery period from 2015 to 2019. This undervaluation is significant because it coincides with the anticipation of future interest rate cuts by the Federal Reserve. Lower interest rates will stimulate demand for real estate by reducing borrowing costs for both individuals and businesses, ultimately benefiting REITs. Moreover, REITs will be able to refinance existing debt at lower rates, improving their profit margins and boosting dividend payouts to investors.
The benefits of lower interest rates for REITs extend beyond increased demand for real estate. REITs utilize leverage to finance their acquisitions, and lower borrowing costs allow them to expand their portfolios and generate higher income. The current leverage levels of REITs are still below historical highs, indicating ample room for expansion. As REITs increase their leverage and acquire more properties, their net asset values (NAVs) and overall income will rise, leading to higher dividends for shareholders. This trend is already evident, with REIT dividend payouts surpassing pre-pandemic levels despite current REIT prices being lower than during that period.
Beyond the general positive outlook for REITs, certain sectors within the industry are experiencing particularly strong growth, irrespective of interest rate trends. Infrastructure REITs, data center REITs, and cell tower REITs are prime examples of sectors benefiting from secular tailwinds. Furthermore, other sectors like office REITs are recovering from the pandemic-induced work-from-home trend, with many companies now mandating a return to the office. This diversified landscape within the REIT sector offers investors opportunities to capitalize on specific growth areas while mitigating potential risks associated with specific segments like residential real estate.
For investors seeking exposure to the REIT sector, closed-end funds (CEFs) offer a compelling alternative to exchange-traded funds (ETFs). CEFs, like the Cohen & Steers Quality Income Realty Fund (RQI), often provide higher dividend yields than ETFs due to their ability to utilize leverage and invest in a more concentrated portfolio of REITs. RQI, for instance, boasts an 8% dividend yield, significantly higher than the typical REIT ETF. Furthermore, CEFs can trade at discounts or premiums to their NAV, creating opportunities for arbitrage. RQI currently trades at a slight discount to its NAV, potentially offering investors an additional layer of upside. Moreover, RQI’s portfolio is strategically positioned towards high-growth REIT sectors like telecommunications, healthcare, and data centers, while maintaining a relatively small allocation to single-family homes, mitigating potential downside from a housing market correction.
