In this podcast, Motley Fool analyst Deidre Woollard and Motley Fool contributor Matt Frankel discuss: 

  • How REITs differ from stocks.
  • Publicly traded REITs vs. private REITs.
  • One office REIT that's evolving.
  • Ways to spot a yield trap.
  • REITs benefiting from e-commerce trends.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

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This video was recorded on Jan. 21, 2023.

Matt Frankel: The whole premise of a REIT is that it's not economical for all of these businesses to own their own real estate. It's not economical for companies like Walgreens to own the buildings they operate in, which creates an opportunity for companies like Realty Income. There's a whole bunch of examples like that where it just doesn't make sense to own your own real estate. That's one thing that I think the market's really overlooking when it comes to data centers.

Chris Hill: I'm Chris Hill and that's Motley Fool contributor Matt Frankel. Despite a down market, some real estate trends aren't going away. That's part of what Deidre Woollard and Matt discuss in this episode, along with the fundamentals of REITs, how to spot a yield trap, and investment ideas in warehousing, retail, and a couple of ETFs. 

Deidre Woollard: Not a great year for REITs in 2022. The FTSE, the all-equity REIT number for the year, that came in at a negative 24.95%. That's not great. It's below the S&P, it's below the Dow. Not as bad as the Nasdaq, tech had a worse year than REITs, but 2021, REITs were total rockstars. Usually, REITs are the steady part of my portfolio. What's the story here? What's the volatility? Why did this happen this way?

Matt Frankel: You're right in the sense that REITs usually aren't so volatile, but you have to remember that neither are interest rates. Interest rates have been particularly volatile this year. Usually REITs move a whole lot slower than they have over the past year. It's really rare for, say, the mortgage rate to double in a single year. REITs are very rate-sensitive instruments. They're designed to pay out steady income, and income-focused investments generally are very sensitive to changes in yields. When you think about it this way, if the 10-year Treasury is paying 2%, a REIT index fund that's paying 4% seems pretty appealing to income investors.

But if the 10-year Treasury that's risk-free is paying 4%, all of a sudden, a 4% yield from a REIT fund might not seem that appealing. In order for REITs to keep up with the market, rates have to rise, the yields have to rise, and because yield and price have an inverse relationship, it generally puts a lot of pressure on REIT prices, and that's really what we saw in 2022. It wasn't that the businesses were doing poorly, we didn't see massive amounts of tenants not paying their rent, we didn't see a lot of vacancies, if anything, REITs business-wise did better than they had been. But it's really a function of just the yield environment and what it does to income investments.

Deidre Woollard: Well, that's a really good point. Another thing about REITs is the impact of interest rates in terms of trying to keep buying new properties. Looking forward, do you think that we're going to see more mergers and acquisitions or more acquisitions in general? Is the cost of capital too high for REITs right now?

Matt Frankel: There's actually a lot to unpack in the cost of capital. When you think about it, there's two different ways that REITs generally fund their growth. Three, but the two main ways are by selling new shares, which I mentioned when yields rise, REIT prices go down, so it's less desirable to sell shares and dilute shareholders to raise money that way. Or they can take on debt, which as you mentioned, is at a much higher interest rate. Growth becomes a little more difficult in this environment. The third way is using some of the cash flow that you're not required to pay out as dividends in order to fund growth. That's usually a minor way to fund growth for REITs.

REITs with a lot of cash on their balance sheets going into this are in very good shape. That's where you're starting to see a lot, and you're starting to see a lot of private equity takeovers of REITs over the past year. Just some of our favorites, unfortunately, got taken out over the past year, American Campus Communities, STORE Capital is about to go private. These are going private because one, private equity investors or alternative asset managers are seeing a lot of demand for investments that aren't stocks right now, which isn't a big surprise because of what the market is doing, people are like, get me out of here, let's get into something that's a little more stable and predictable or at least that I don't have to look at the price every day.

You're seeing a lot of demand on the private equity side. You're seeing a lot of take-private transactions. As far as mergers and acquisitions, I could see it coming back a little bit in 2023, a lot of REITs are very financially strong. REITs that have A credit ratings can still borrow relatively cheaply, but as far as just the flurry of M&A and the flurry of debt issuance and rapid growth that we saw over the past decade or so, actually, I'm expecting muted growth in 2023.

Deidre Woollard: When you say muted growth, what does that also mean for the dividends? Because that's one thing that people are looking at with REITs. Obviously, you just talked about 2022 being not-so-great. Should we be looking for better dividend performance going forward?

Matt Frankel: Well, a lot of them raised their dividend significantly in 2020. Think of industrial REITs that are getting 30% more for the same leases than they were before the pandemic. They've passed some of that onto their shareholders. The general goal with REITs is you don't think of it in terms of a year-to-year dividend increase, you want your income to grow over time. The general goal when I invest in a REIT is that I want to see its dividend rise at an annualized rate of 4%-5% over the long run. That's what I aim for and I consider that to be strong dividend growth.

Remember, REITs have to pay out 90% of their taxable income, but there's a lot more to that than a lot of investors realize. This doesn't mean that if a REIT makes a dollar in profit per share, they have to pay out 90 cents of it. They have to pay out 90 cents of their taxable income, which can actually vary a lot from year to year. REITs have the tax deduction of depreciation, which in a lot of cases can chop their earnings in half for tax purposes, even though they're making a lot more money. But with that in mind, REITs are still making money. But I'm expecting, I hate to use the word muted again, but muted dividend increases this year. Because of that high cost of capital, it's putting a strain on growth.

If a REIT doesn't have to give a 5% dividend increase, if they can keep their streak alive with a 2% increase and satisfy the requirements to remain a REIT by handing out at least 90% of its taxable income, from a REIT's perspective, that's a way to retain some of its earnings and reinvest that in growth instead of diluting shareholders by issuing new shares or taking on more debt or things like that. I'm expecting REITs to raise their dividends just enough this year to keep their dividend streak alive, but nothing like the 10% dividend increases that you've seen in some recent years.

Deidre Woollard: That makes sense. I like the way you framed that, how it's a bit of a balancing act for REITs trying to keep all of those things equal and still deliver on what people expect, which is of course those steady dividend increases. I'm excited to talk about sectors with you, and especially I wanted to talk about office because I feel like you and I have had this conversation for so long and I love having it with you, but I want to take it in different direction this time. I want to talk about one of your favorite REITs, Empire State Realty Trust. For those of you who don't know, this is one of Matt's favorites. It owns the Empire State Building and a lot of other buildings, but it's doing something interesting that other office REITs are also doing which is getting into other sectors. If office isn't dead, but office is shifting, does it make sense for some of these bigger office REITs to look at differently, do they need to change up their property mix?

Matt Frankel: First of all, you hit the nail on the head with the office isn't dead, but it's different. You have to be a lot more selective than you used to. I would compare that to say the calls that the mall is dead five years ago. The mall wasn't dead, people just wanted to go to the good malls. You saw Simon Property Group is doing off-the-charts well, which we'll talk about later in the show. But the regional malls got hammered, even the decent quality regional malls got hammered. The same thing is starting to happen with offices. If there's something special about an office property, be it the location, the history like the Empire State Building, you're still seeing a lot of tenant demand for office space.

It would be nice if someone had been saying this all along, but employers are starting to realize that there is an element of productivity and collaboration that comes with being in person in the office. You're starting to see more and more of the companies that said they were going to be remote forever start to switch to you need to be in the office two days a week if it's practical, things like that. Office isn't dead, companies want office space. There's a big element of collaboration there. They have to be selective. But on the second point of should office REITs start to buy other things like you mentioned, Empire State and their apartments, it is a good time to do some, what I'd call opportunistic diversification.

At the time when Empire State bought its apartment buildings that you're referring to, a lot of people were saying that inner-city apartments were dead. No one's going to want to live and pay New York City prices if they don't have to live in the city because they can work remotely. From everything I can tell, just analyzing it, they got a deal for those properties. I think that diversification, especially when it's opportunistic like that, is a good thing. Office REITs should do what they're comfortable with. An office REIT, just because their properties aren't doing well, shouldn't just run out and buy a mall, because that's not in their circle of competence. Empire State in particular knows New York City very well, and they're not buying an apartment building in Albuquerque, they're buying apartment buildings that are right around the corner from their office buildings, areas they know very well that they can analyze very well, their managers live around the corners from, that's their circle of competence, is New York.

It's not necessarily office because their office buildings have retail elements, they have entertainment elements to it. The observatory on top of the Empire State Building. They have experience with a few different property types, but all within the context of the New York City metropolitan area, which is where they're sticking to. The short answer to the question is yes, diversification is probably a smart move for them with the office uncertainty, but I don't think office is dead, and I think if you have the knowledge, it's really a nice luxury to have three or four different avenues that you could direct your capital to when you see opportunities.

Deidre Woollard: I like what you said there. I think it's a good reminder for investors that anytime you see the headlines of something is dead, don't immediately agree. Question that, look around. I also like what you said about how REITs need to know what they're good at and what they're good at might not be just what you see on the surface in terms of sector. I wanted to talk about another sector I'm thinking a lot about lately and that's multifamily.

You just mentioned it with Empire State Realty, it's going to be an interesting year for multifamily. Rents have been up, but they're slowing, vacancies are rising. There was a report recently from CoStar from their about absorption, absorption of newly built units that has been slowing down, and yet we also have the housing shortage. Some of this is, I think that we're building a little too much at the high end of things, but it's going to be an interesting year for multifamily. What are you seeing?

Matt Frankel: You mentioned that CoStar report where they said limited absorption of newly built units is driving up vacancies, that's generally at the higher end. You're seeing the worst hit at the higher end. The housing shortage, we've all heard the headlines, there's a shortage of about 4 million housing units, give or take, depending on which report you are reading. What people don't realize, it's almost exclusively starter homes that are just non-existent and that's on the rental and ownership side. Let me just give a couple of statistics that I find really just mind-blowing. In the 1970s, the average rate of construction of entry-level homes, which we generally define as under 1,400 squire feet, enough space for a new family and things like that, was about 418,000 per year in the United States.

By the '90s, that had been cut in half to about 207,000 in the average year in the 1990s. In the 2010s, the past decade, the most recent decade, 55,000 a year, almost about 1/9th of what it was in the 1970s. It's pretty much stabilized at that for now in 2022, 65,000 so-called starter homes have been built. But in 2020, 65,000 starter homes had been built, but there were 2.4 million first-time homebuyers in the market. People were buying a lot of house, and now that the mortgage rates are higher, home prices are higher, it's a lot more difficult to afford that, we're starting to see a trend in the other direction, but there's not enough being built. Short answer to your question is that we need more entry-level housing units and we need rent to stabilize.

Rent, it's starting to pull back a little bit, but I wouldn't call it stable in any way. If you look at a chart of rent prices in the U.S., it looks like a checkmark right now, it doesn't look like any type of flat graph that you up and then just down. Rent needs to stabilize and we need to see a lot more entry-level units, especially even on the apartment side of things. We've spent a lot of time talking about built-for-rent housing, but the average built-for-rent home right now is about 2,500 square feet. It's still an expensive place to live, and it's pricing a lot of people who need homes out of the market. It's all about entry-level homes. I think entry-level housing construction in general is going to be a massive investment opportunity over the next decade or two.

Deidre Woollard: You and I have talked before about where that housing is, too, and the migration that we were seeing certainly before the pandemic, but increasingly during the pandemic. We've talked about the Sun Belt, it's always the Sun Belt. Although some of those markets got too hot, too fast, I'm thinking about Austin, Texas, but some of the markets have longer-term staying power, certainly in North Carolina and around the Research Triangle. It's important to, I think, to think about where the housing is, where we're going, where population is growing. It's a complicated thing. I think it's something that we're talking about publicly traded REITs.

But I wanted to shift a little bit because the non-traded REITs are trying to figure this out, too. With Blackstone's, they recently paused redemptions. For the non-traded REITs, it's a little different. You can't trade a like a publicly traded REIT, you have to redeem your shares. Usually this happens pretty regularly, but it's almost a little bit like a bank run. I hate using that phrase. But is there a high-profile redemption like little bit of panic going on? Is that anything that would bleed over into the public REIT market in terms of how people are considering REITs?

Matt Frankel: A redemption pause is a necessary evil for private REITs, I would say. It prevents them from having to sell a lot of properties to cover redemptions at fire-sale prices. If I were to tell you you have to sell your house within the next 10 days to get the money, you probably wouldn't get full market value for it. It prevents them from having to sell assets when they don't want to and things like that, but I also think it tells us that public REITs are the way to go for 99% of investors. It's something that you just don't like to see.

You want a REIT because you want access to your money. If I want an illiquid real estate asset, I'll buy a rental property. This would be like if Vanguard said you can't redeem its mutual funds. Obviously, that's a gigantic scale, if Vanguard said we don't have the money for redemptions that would crash the market. But it's the same idea, where you are saying, we don't want people to pull their money out of the fund as quickly, let's hold off. But for me, it's one of the big reasons why I invest in rental properties and publicly traded REITs. The private REITs are in that middle ground. They can be very lucrative investments if you don't care about liquidity.

Deidre Woollard: I invest in some of the real estate crowdfunding, Fundrise and RealtyMogul, and we haven't heard anything major on those yet, but definitely I know that that's something that they're looking at, too. Our producer had a question that I think is worth considering, which is real estate trends that aren't going away, and I'm going to start with one, industrial real estate. As we're taping this, Prologis had their earnings today, and a lot of companies are, they scaled back their use of warehouses last year, certainly most famously Amazon. I'm not worried about industrial in the long term. What trends are you watching that you think aren't going away?

Matt Frankel: First of all, I totally agree with you on industrial demand for warehouses is strong, and fulfillment spaces, things like that are very strong from the long term, but they can be rather cyclical, and they tend to anticipate cycles rather than react to them. What I mean by that is you're seeing a lot of operators like Amazon and things like that, they're getting hesitant to invest in new warehouse space at a time when they think the consumer is going to stop spending. It can be cyclical, but the long-term trend is fine. Data centers are another example of one that I think gives a great opportunity right now because that is massive long-term trends.

Forget the short-seller calls. I know Jim Chanos has come out publicly and said that the data centers are his big short, I don't buy it. His thesis is that the tech companies are going to start bringing data centers in-house, they don't want that capital commitment. Maybe like the Apples of the world, don't care and have hundreds of billions of dollars to build their own data centers. But the tech start-ups that pride themselves on being asset-light businesses are not going to shy away from data centers. They might stop spending for the next year or two similar to industrial tenants. They might stop investing in growth in times of uncertainty, but your long-term that trajectory is still very positive.

Deidre Woollard: I love that, too. I've been thinking about the data centers, too, totally agree with that because I think it's akin to industrial. Amazon is a huge tenant of industrial REITs, but they also build their own. With data centers, it's the same thing. Alphabet and Meta, they build their own data centers. At the same time, they're also tenants of the data center REITs because they want that flexibility and that's important. They don't want it all on their shoulders for some really good reasons.

Matt Frankel: It's the same reason that Facebook doesn't own most of the office buildings it's in, it leases them. It wants to keep its capital commitments low, even though it could afford to buy them. But the whole premise of a REIT is that it's not economical for all of these businesses to own their own real estate. It's not economical for companies like Walgreens to own the buildings they operate in, which creates an opportunity for companies like Realty Income. There's a whole bunch of examples like that where it's just doesn't make sense to own your own real estate. That's one thing that I think the market is really overlooking when it comes to data centers.

Deidre Woollard: Well, you teased it earlier in the show talking about retail, so let's go into that a little bit. Last year, a great year for retail, great year for foot traffic. We kept using the term "revenge spending," but people wanted to go back to the malls certainly, but they also wanted to go back to the grocery stores, which I thought was interesting. Everybody got their Instacart accounts, but when they could, they wanted to go back and do more shopping. I've got favorites in both the shopping center side and the mall side, and I think you mentioned Simon, we both share that one, what else are you watching when it comes to retail?

Matt Frankel: Well, for one thing, it wasn't just the foot traffic was up. It's that we saw occupancy for the first time in a long time trending the right direction. One that I follow his Tanger Outlets which along with Simon dominate the outlet industry. Simon's No. 1 by far with its premium outlets, and then Tanger is the big stand-alone, ticker's SKT on that one. They're both doing great, not just in terms of foot traffic they are, both of their tenants have never been making more money per square footage basis, which allows them to raise rent, but their occupancy is trending in the right direction as well. The outlet industry is very conducive to the e-commerce shift we're seeing.

It's a much more economical way for retailers to maintain a vast physical presence without having to pay high-end mall rent. Outlets are generally very cheap rent-wise compared to space in a mall. One of the reasons that both premium outlets -- you know, Simon -- and Tanger have been raising occupancy is that they're bringing companies that historically don't have an outlet presence into their system. We've talked about the malls being dead. The malls aren't dead, the high-end malls are fine, but the mid-level malls, a company like Abercrombie & Fitch, might start closing some of its underperforming stores in mid-level malls, and shifting more of those resources to outlets where it can be a much more economical way to have that physical presence. I'm very bullish on the outlet space. Companies that just generally have an online presence are starting to open up outlets.

Companies that are big-box stores are starting to open up smaller outlets to get rid of merchandise that they need to get rid of. Dick's Sporting Goods opened its first outlet during COVID in a Tanger property. For me, outlets are the area of retail that I'm most bullish on over the next, say, 20 years, but if you're worried about cyclicality, if you're worried about recessions, the grocery anchored, like you mentioned, is a fantastic way to go and that's one that's just not going anywhere. Now, you have to be selective. It's just like the malls where you want your properties located in good areas, you want them to be relatively young, you don't want a REIT full of old strip malls that just happened to grocery stores in them. Kimco's, one of my favorites in that space, KIM, that's probably what you were going to say, but I think Tanger is probably my favorite retail stock right now in terms of real estate and with Simon and Kimco being a close second and third.

Deidre Woollard: As we wrap up here, if you're an investor and you're starting with REITs, we've talked about different sectors, does it make sense to just go for an ETF or should you try to pick a favorite in each sector?

Matt Frankel: Well, picking favorites is definitely good if you have a good working knowledge of the stock market in general and how to evaluate REITs. I know we have some good guidance on the Fool. As far as the ETF route, there's absolutely nothing wrong with that, and it's a great way to add diversification if you're say, mostly a tech-focused growth investor, adding a REIT ETF can be a good move. I'll tell you, too, that I really like for beginners, there's the Vanguard Real Estate ETF that I mentioned a lot. VNQ is the symbol on that one. The biggest problem with that is it's very top-heavy. There are some really big REITs like American Tower, Crown Castle, Prologis, Equinix, but then there's a lot of really small ones.

I don't know the exact percentage off the top of my head, but it's something like 30 percent of that fund's assets are concentrated in like four companies. If you don't want that kind of exposure, Invesco does have an equal-weight real estate ETF that invests in the exact same index. The ticker symbol for that one is EWRE, and it splits the money equally. A company like Prologis has the same weight as say, Simon Property Group, which is a couple of times smaller than it. An equal-weight fund could be a nice option for newer investors if they don't want that much exposure to say the big communications REITs because that's really what the big ones are. They're all very similar in nature and you would have very limited exposure to things like retail REITs like we're talking about, which tend to be relatively small compared to those.

Those are two ETFs that are perfect for beginners. REITs are nice sector where it's not that tough to find stable companies. It's not like investing, if I wanted to buy say, cybersecurity stocks, it's a lot tougher to pick the winners, pick the companies that are still gonna be here in 10 years, things like that. In the real estate sector, it's not, and that's a luxury that newer investors can use to their advantage. It's less guesswork. A company, like would we mention Prologis, what's the chances that Prologis will zero X in the next 10 years. It's almost nil. I actually would call real estate probably the most beginner-friendly sector in the stock market.

Deidre Woollard: I would definitely agree with that, although I think they're absolutely ways you can still get yourself into trouble just like any other sector.

Matt Frankel: Absolutely. Stay away from yield traps. If a REIT that owns properties yields more than say, 7% or 8% and there's not a really good reason why, you should probably stay away from it. Yield traps are the way you get in trouble in real estate.

Deidre Woollard: That is really good advice. As we wrap up, I want to pivot away from the beginner and to something like, if you want something risky, there are things in real estate, they can be a little riskier, maybe as a smaller REIT or something like that, what's something you would maybe look at?

Matt Frankel: The riskier REIT that I'm looking at right now is Innovative Industrial Properties. That's known as the marijuana REIT. They own legalized marijuana production facilities mainly. It's mostly in industrial REIT and they rent out to those very specific group of tenants. The risk is, what happens if one of those tenants goes bankrupt, which one of them just did? The re-leasing and everything like that can be very tricky. Those are very purpose-built facilities. It can be very tough to re-lease those.

But having said that, the operators that they do have signed 15- to 20-year leases, so as long as they're in business, it's going to be a very steady income stream, it's really a well-run company, but it's one that does have its risks. For example, their tenants are generally outside of the main banking system. They're usually cash businesses. Right now, marijuana is still federally illegal, so they're tenants can open an account at Bank of America for their businesses. There are some unique risks, but after, I think it's down like 70% from the highs right now, and still making very good profits. It's one that I'm watching very closely right now.

Deidre Woollard: That one is interesting because it got so caught up in that cannabis hype cycle that I think it went up a lot more than it should have and then it went down with the cannabis hype cycle, which happens because sometimes people, when they get caught in the hype cycle, they don't look at the underlying fundamentals. I liked that you bring that one up. I think they have an interesting way of expansion, too.

Matt Frankel: There are a bunch of interesting ones on the radar right now, but most of the REITs I like aren't that risky. It's just that they're beaten down and paying great dividends because of that yield sensitivity that I mentioned. There are some great REITS right now paying 6% or 7% dividends with a lot of growth potential. So I don't really need to venture too much into the realm of the risky right now. Investors can get great returns just by staying safe. 

Chris Hill: As always, people on the program may have an interest in the stocks they talk about, and the Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.