Last year was brutal for the real estate investment trust (REIT) sector. Rising interest rates created two headwinds for the industry. They made it more expensive to borrow money, making it harder for REITs to finance investments. Meanwhile, higher rates made lower-risk investments like government bonds and bank CDs more attractive to income-focused investors, causing REIT stock prices to fall to compensate investors for their higher-risk profiles. These issues caused REITs to lose about a quarter of their value on average last year.
Some REITs were down even more due to additional pressure points. Two particularly hard-hit REITs were Digital Realty (DLR 0.20%) and Medical Properties Trust (MPW 8.02%), which have plunged more than 40% since the start of 2022. While those REITs were down sharply last year, they could bounce back big-time in 2023.
Leveraging its pricing power
Shares of Digital Realty have fallen nearly 43% since the beginning of last year. That shellacking has driven the data center REIT's dividend yield up to 4.8%. While higher interest rates have weighed on its stock price, that's not the only issue. The company has also battled foreign exchange headwinds and concerns about a slowdown in tech-related spending.
NYSE: DLR
Key Data Points
However, demand for data center solutions remains strong. The company reported a record $176 million of new bookings in the third quarter. That was the third time in the last four quarters that bookings exceeded $150 million.
The company believes these strong demand tailwinds will remain in place. CEO Bill Stein noted on the third-quarter call: "Looking ahead, sales activity remains healthy as the secular trends driving data center demand remain in place. Enterprises continue their digital transformation with a growing preference for hybrid cloud architecture while cloud and connectivity providers continue to expand their infrastructure to better serve their customers around the world."
The company is also starting to use its growing global scale to capitalize on its pricing power. One way it's doing that is by negotiating annual rental rate escalations clauses in its leases tied to inflation instead of fixed-rate yearly increases. During the third quarter, 40% of leases signed had inflation-linked escalators, double the percentage of its legacy contracts.
In addition to that embedded rent growth, Digital Realty should benefit from its extensive development pipeline. The company has a large backlog of projects and has already pre-leased 60% of the capacity. Meanwhile, it recently closed its acquisition of a majority stake in an African data center platform.
At some point, the market will realize that Digital Realty isn't experiencing any decline in data center demand. That realization could send shares soaring. In the meantime, investors get paid well while they await the recovery.
Getting back to full health
Medical Properties Trust's stock has tumbled over 47% since the beginning of 2022. A big factor was concerns about the healthcare REIT's liquidity as interest rates rose. That slump pushed its dividend yield up over 9%.
NYSE: MPW
Key Data Points
However, the company has addressed those potential concerns over the past year. It sold several assets and received payoffs on some loans, generating $1.8 billion in proceeds. It used that money to fund new investments and strengthen its balance sheet. As a result, the company ended the third quarter with its leverage ratio down to 5.8 times, which is right on the borderline of investment grade.
Meanwhile, the company has signed deals to provide more than $650 million of additional liquidity this year. That's more than enough money to satisfy the company's upcoming $446.8 million loan maturity if it doesn't refinance that debt.
Another potential concern investors had with Medical Properties Trust was the health of Steward, which is its top tenant. However, Steward has made significant progress in improving its financial situation over the past few months. That company completed the accelerated repayment of $450 million of COVID-related advances and collected $70 million of past-due reimbursements from Texas' Medicaid program. Along with other changes, that company expects to start producing sustainable and positive free cash flow. Meanwhile, Steward also extended an important loan maturity for a year. These accomplishments put the company in a much stronger financial position, enabling it to continue paying rent to Medical Properties.
With Medical Properties Trust shoring up its balance sheet and Steward's financial position improving, the pressure on the REIT's stock price should fade in 2023, especially if interest rates stabilize.
Poised for a potential rebound
Rising interest rates and other issues weighed heavily on Digital Realty and Medical Properties Trust last year. However, some of their headwinds should start improving in 2023. As they do, their stock prices could bounce back big time. That makes them great stocks to consider buying ahead of that potential recovery.
