You can probably find a certificate of deposit (CD) with an interest rate of around 5% today, which is a problem for dividend stocks like real estate investment trusts (REITs). Simply put, that's a lot of yield without having to take on the inherent risk of owning stocks. But with a CD you miss out on the potential for income growth over time, which is why even conservative income investors should have at least some dividend stock exposure. A pullback in REITs has opened up an opportunity to buy industry-leading names like Realty Income (O -0.17%) and Simon Property Group (SPG -0.26%).
Interest rates are a big issue
While rising interest rates have caused some conservative income investors to shift toward options like CDs, that isn't the only headwind higher rates pose to REITs. Buying institutional-level rental properties requires a lot of money and REITs tend to have large payouts, so they have to use stock sales and debt issuances to pay for acquisitions. When rates go up, the costs a REIT faces go up too.
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Eventually property prices adjust so that returns remain attractive enough to keep REITs investing. But there's usually a lag, because sellers don't want to lower prices until they absolutely have to. That may not happen until mortgages or other debts have to be rolled over at the current higher rates, at which point selling may be the only option for smaller players and property developers.
Interest rates are still in a state of flux and property markets haven't yet adjusted to the swift rise in rates. That's among the reasons shares of Realty Income and Simon have fallen by nearly 30% each since rates started to rise in early 2022. But that could be an opportunity for long-term dividend investors given their industry positions and attractive yields.
Data source: YCharts
Bigger is often better in the REIT sector
Realty Income has a market cap of almost $39 billion. It is more than three times the size of its next closest competitor in the net-lease niche (net leases require tenants to pay for most property-level operating costs). Mall owner Simon Property Group has a market cap of about $46 billion, which makes it more than 10 times the size of its next closest peers. These are both, hands down, industry bellwethers.
They each have an investment-grade-rated balance sheet and long histories of operational excellence behind them. Realty Income's dividend has been a steady grower, with 29 years of annual increase. Simon's has been more variable, with a cut during the Great Recession and another one during the coronavirus pandemic and the economic lockdowns. However, the dividend has grown again after each of these financial dislocations.
Data source: YCharts
That said, the key here is being large and financially strong. That affords these two REITs the ability to do things that their peers can't. The biggest one is spending money on big development projects and continuing to buy assets, including smaller peers, when times are tough. For example, Simon just started construction of an outlet center in Indonesia that it expects to open in 2025. It has a number of other projects, both domestically and internationally, it was already working on as well.
Realty Income, meanwhile, just agreed to buy peer Spirit Realty (SRC) following an investment in the Bellagio, a major casino in Las Vegas. During the Great Recession, Simon bought a controlling stake in rival shopping mall operator Taubman Group. In other words, even when times are tough, these two industry giants can continue to invest for the future.
That comes on top of the benefits that scale affords. Realty Income and Simon spread their corporate costs over more assets, keeping overall expenses in check. They can also use their size to negotiate with vendors and tenants more aggressively than a smaller company might. That gives them an edge, but it can be a particular advantage when times are tough and negotiations become more challenging. Their size can also afford them better access to capital markets, since their stocks are likely to be more liquid and the combination of size and financial strength will make their debt more attractive to institutional investors.
Data source: YCharts
Go with the biggest and best
The drop in REIT shares has opened up opportunities throughout the sector. So it would be hard to suggest that Realty Income and Simon are the only REITs you could be looking at during this industry-wide dip. But sometimes a stock price decline doesn't translate into a great investment opportunity.
The key with Realty Income and Simon is that they are industry leaders in their respective niches. And not by small margins, given their scale relative to peers. The real opportunity today is to trade up to the best names while they are on the sale rack. Don't miss out by prioritizing yield at the expense of quality.
