What happened
Last year was brutal for the real estate investment trust (REIT) sector. The average REIT delivered a total return of negative 25% for the year. Many fared even worse.
However, REITs bounced back sharply in January. The sector's total return was slightly more than 10%. Several REITs gained more than that, according to data provided by S&P Global Market Intelligence. Among the notable names to rally last month were Digital Realty (DLR 1.60%), EPR Properties (EPR -0.12%), Medical Properties Trust (MPW -0.43%), and STAG Industrial (STAG -1.44%):
Let's look at what drove their rebound last month and whether their recovery can continue in 2023.
So what
The big factor weighing on REITs in 2022 was higher interest rates. The Federal Reserve aggressively fought inflation by increasing the federal funds rate from near zero at the start of the year to around 4.5% by the end of the year. Higher interest rates make it more expensive for REITs to borrow money to fund acquisitions and development projects. It also makes other yield-focused investments like bonds and bank CDs more attractive. Because of that, REIT share prices fall, causing their dividend yields to rise to compensate investors for their higher risk profiles compared to those income alternatives.
After raising rates sharply last year, the Federal Reserve has taken a different tone in 2023. As inflation starts to slow, the Fed appears poised to slow the pace of rate hikes in 2023. It most recently increased rates by 25 basis points, its smallest increase during the current rate-tightening cycle. The Fed could take a wait-and-see approach before increasing rates further.
A more stable rate environment should benefit REITs. It should give them more clarity on borrowing costs. Meanwhile, it will take some of the pressure off their stock prices since investors will have a better idea of how high rates might go.
In addition to rates, other headwinds impacting REITs have started to fade. For example, tenant concerns were a big issue for hospital REIT Medical Properties Trust last year, causing its stock to lose more than half its value. However, its top tenant, Steward Healthcare, has significantly improved its financial position, which has taken some of the weight off the stock.
EPR Properties has also experienced tenant-related headwinds as theater group Cineworld Group filed for bankruptcy. While it didn't pay rent in September, that company did resume paying rent the next month. Raymond James analyst Richard Milligan added EPR Properties to the firm's current favorites list last month while reiterating the strong buy rating and $45 price target. Milligan believes that additional clarity on the Cineworld situation will drive the REIT's share price closer to its net asset value this year.
Meanwhile, macroeconomic headwinds weighed on data center operator Digital Realty and industrial REIT STAG Industrial last year. Investors worried that a slowing economy might impact their ability to secure higher rental rates as leases expire and make value-enhancing investments. However, demand for data centers and industrial real estate has held up well. Furthermore, recent economic data suggests that the economy remains surprisingly resilient. Because of that, those REITs should be able to continue growing their funds from operations (FFO) and dividends.
STAG Industrial recently delivered on the latter, increasing its monthly dividend payment by 0.7% in January. Meanwhile, the relative strength of the industrial market led BMO Capital analyst Eric Borden to give the REIT an outperform rating and set a $41 price target when he initiated coverage in early February. The analyst expects the REIT to report accelerating net-operating income growth this year of 5.3%.
Now what
REITs have started to recover from their nasty slide in 2022. While more clarity from the Federal Reserve on interest rates is helping lift a weight on the sector, many REITs are also benefiting from improving tenant situations or the relative strength in demand for their properties. Further clarity on rates and improvements in tenant situations or macroeconomic demand could help lift more weight off of REIT shares this year. Because of that, the sector could continue to generate strong total returns in 2023.
