Investors seeking shelter from the growing inflationary storm might well consider including commercial real estate (CRE) in their asset allocation. This huge chunk of the economy -- which includes everything from warehouses to cell towers to retail property -- has a history of holding up well when prices are on the rise.
Real estate investment trusts (REITs) provide easy entry into CRE investing. For the price of a single share, you can enjoy the dividend payouts that by law must equal or exceed 90% of the REIT's taxable income. These dividends can often more than make up for any pressure on REIT stock prices, producing market-beating returns. Here's a quick look at four reasons why.
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1. REITs own real estate, and that has real value
The top line here is that REITs own real assets, which in general have been gaining value for a long time. It's reasonable to expected that to continue, as it has through multiple economic cycles. At the same time, it's not a straight or even line, and some sectors, of course, are hotter than others at any given moment. Case in point: Industrial space, especially logistics and warehouse facilities, are at an unprecedented premium. For example, the largest industrial REIT, Prologis, reported recently that rents are rising at a record pace, demand is at an all-time high, and as its chief executive officer, Hamid Moghadam, was widely quoted as observing: "Industrial space is effectively sold out."
2. The stability of leases and rising rents
Landlords and tenants lock in the rent level through leases, which assure REIT investors of steady income flow used to pay out dividends. That's "steady," not "static." Leases typically include rent escalations, which can help blunt the effects of inflation even through the several years that a property is locked up in the average CRE lease.
Of course, leases range widely in duration, and each REIT's portfolio has a mix of expiration dates, so watch for those escalations to be even higher in the hotter sectors as contracts expire amid rising inflation.
Terreno Realty (TRNO +0.10%) is an example of how that can drive profitability. The coastal market warehouse specialist said it was able raise its revenue from new and renewed leases by between 29% and 38% in the third quarter.
And if REIT managers can keep operating expenses stable relative to inflation while raising the rent, that can help sustain or grow funds from operations (FFO), a metric that's closely watched by investors as a gauge of a REIT's profitability. Major industrial REIT Duke Realty (DRE +0.00%) reported that it was able to raise core FFO by 15% in this year's third quarter through higher rents and demand for its new developments.
3. Interest rates and REIT history
The Federal Reserve has just told the market to expect as many as three interest rate hikes in 2022 as monetary policy makers take on inflation.
It's conventional wisdom to assume that interest rates and REIT performance will always move in opposite directions, but that's not necessarily so, according to data from the National Association of Real Estate Investment Trusts (Nareit) and the National Council of Real Estate Investment Fiduciaries (NCREIF).
NCREIF says CRE overall saw positive returns in the 19 quarters with rising interest rates between 1996 and 2017. Nareit data show that while REITs have somewhat underperformed the S&P 500 during periods of low inflation, they've outperformed that benchmark during times of moderate or high inflation. In the 12 months through October, the consumer price index (CPI) rose 6.2%, the highest in almost four decades, while total returns for REITs overall were at 45% before adjusting for inflation.
4. Ultimately, REITs provide liquidity and agility
No two real estate sectors are alike, and every publicly traded REIT has its own mix of property types, lease terms, geographic diversity, and market conditions. But they all share the liquidity that allows investors to buy and sell as they see fit in response to inflation and whatever else this pandemic-battered economy presents as challenge and, ultimately, opportunity.
