The Federal Reserve increased interest rates to help fight inflation, but there are always side effects from such moves. In the case of real estate investment trusts (REITs), the side effect was a deep drawdown across most of the sector.
But Wall Street doesn't go in a straight line, it follows a path that more closely resembles a sine curve, and REITs began to rally toward the end of 2023 as interest rate worries began to ebb. There are still some interesting opportunities in the sector, including Prologis (PLD +1.72%) and Realty Income (O +0.95%).
Here's why you might want to consider buying these two REIT stocks before they surge even higher.
Why are interest rates an issue for REITs?
Broadly speaking, interest rates can be problematic for REITs because REITs regularly have to tap the capital markets for growth capital. This isn't exactly different from any other company, but it is more acute because REITs pay out most of their cash flow as dividends. This means that any growth investment, be it buying a property or building one, necessitates either selling debt or issuing stock. It simply got more expensive to be a REIT as rates moved up.
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There's another issue here as well since rising rates can lead to an economic slowdown. Or worse, tip an economy into a recession. For Prologis, which operates in the industrial space, and Realty Income, which has material exposure to retail assets, a recession could translate into weaker occupancy numbers and more difficult lease renewals. So that's a second thing to consider here.
But those concerns start to fade if interest rates flatline or, as some now hope, begin to fall. Since Wall Street tends to be forward-looking, it boosted the shares of both of these stocks at the end of 2023 as anticipation began to build for a reversal in the Federal Reserve's interest rate approach in 2024. Over the past three months, Prologis' shares are higher by around 20% while Realty Income is up about 15%.
There's still more room to go
Those are pretty big gains in a very short period of time, so investors need to step back and take a closer look at what they are buying. For starters, Prologis is still off nearly 25% from its 2022 high with Realty Income down 27% or so from its 2020 peak. In other words, neither of these two REITs have fully recovered all of the ground they lost. That suggests that there could still be more upside from here. And it could be fairly substantial.
But the real attraction of these two REITs is their positions within the respective niches they serve. Prologis, with a market cap of $120 billion, is one of the largest REITs in existence. Realty Income, with a market cap a touch over $40 billion, is more than twice as large as its next closest peer. Cost of capital is a key point of differentiation in the REIT world, and both of these REITs have the size to more easily access the capital markets than their competitors. Then there's the benefit conferred by being able to execute deals that are simply too large for smaller players to touch, which is another important differentiator.
On top of that, both Prologis and Realty Income have globally diversified portfolios. Prologis has a greater geographic reach, offering lessees a single source for warehouse space across North America, South America, Europe, and Asia. The company also happens to own development land in all of those areas as well, so it can grow along with demand (or just sit on the land, waiting for demand to develop as the global economy grows).
Realty Income's foreign exposure is largely in Europe, where the net lease approach (requiring tenants to pay most property-level operating costs) is still relatively new. So there's a notable growth opportunity in the region, particularly for a REIT large enough to do big deals and be a trusted partner.
All of that is to say that the fundamentals for Prologis and Realty Income remain strong. For added proof of that, Prologis was able to increase rents by an average of roughly 50% in the third quarter of 2023 on renewing leases. And Realty Income was able to recapture 106.9% of expiring lease rents as it signed new deals. These are not businesses that are struggling today, despite the still relatively dour view on Wall Street.
Give these REIT giants a second look
If you fear you have missed out on the REIT recovery, don't get too upset. There are still some industry-leading stocks that appear to offer additional recovery potential. That said, it might make sense to stick with the largest and best-positioned competitors, like Prologis and Realty Income, since both continue to execute well on the business front.
