Higher-for-longer interest rates have spelled trouble for real estate investment trusts over the past two years. But with valuations looking attractive and the Federal Reserve seemingly poised to start lowering rates, dividend-paying REITs may offer opportunities for long-term investors.
Currently, all REIT sectors in the United States are trading below Morningstar’s fair value estimates. “The rapid rise in interest rates and slowing economy over [the] past two years have led to major valuation declines across the sectors,” says Morningstar senior equity analyst Kevin Brown. He thinks there was a market overreaction regarding commercial real estate because of “higher interest rates, lower liquidity, tighter capital market conditions, and slowing net operating income growth,” which led to a “significant correction in the stock prices of various commercial real estate REITs in the past year” that was “overdone.”
Brown continues: “Many REITs have a dividend yield today that is higher than their historical average, and we believe that dividend yields are currently attractive.” He thinks REIT stock prices will continue to move in the opposite direction of interest rates. “We anticipate … share prices will rise, and that dividend yields will fall as the Federal Reserve cuts interest rates.”
REIT Dividend Yields and 10-Year UST
These are Brown’s top REIT picks in four key sectors:
- Office REITs: Kilroy Realty KRC
- Residential REITS: Sun Communities SUI
- Healthcare REITS: Ventas VTR
- Triple-New REIT: Realty Income O
REITs vs the US Stock Market
Hotel and Triple-Net REITs Attractive
Brown’s two favored REIT sectors are hotels and triple-net, which tend to be longer-term and provide steadier income, since tenants pay property taxes, insurance, and maintenance costs. “Hotel REITs have performed in line with or slightly worse than the market over the past two years, so there is a generally negative view of them at the moment,” he says. “However, the REITs are concentrated in the upper upscale segment, which should see relatively higher demand growth over the next several years compared to the overall market (though that is somewhat offset by higher supply growth).”
The industry recovered somewhat quickly from the pandemic as vaccine rollouts made leisure travel possible again, though business travel has not fully recovered (and it may not, due to the prevalence of virtual meetings). More recently, the travel recovery has slowed due to high inflation. Many people are more hesitant to spend on travel with the costs of necessities rising.
Pebblebrook Hotel Trust PEB, Park Hotels & Resorts PK, and Host Hotels & Resorts HO completed major renovations across their portfolios, which Brown believes put their revenue growth in line with the market. As renovations drive higher rates and more business, he projects that these firms will outperform the market in revenue and margin growth.
The triple-net sector is particularly impacted by changing interest rates, and Brown focuses on one company in particular. “Realty Income is most sensitive to interest rates,” he says. “The rising rates over the past two years has led to the name underperforming.” So if interest rates fall, he suspects Realty Income would hugely benefit. At the same time, Brown believes “the negative impact of interest rates on the company has been overblown,” since its growth relies on acquisitions. “Many feared that higher rates would mean acquisition volume would decrease, the spread on cap rates over debt issued to finance the acquisitions would shrink, or both,” he says. But this is not the case. 2022 and 2023 were the company’s largest years by acquisition volume, with each achieving over $9 billion.
Office REITS: Cheap but Risky
Morningstar equity analyst Suryansh Sharma says the office, industrial, and self-storage sectors are not as undervalued as hotels and triple-net: “Some names in offices are cheap, but it is also a risky bet.” Since the pandemic, many employees are still hesitant to return to the office, “keeping physical office utilization levels stuck at around 50-55% of pre-pandemic levels,” he says. High interest rates, weaker employment growth, and a generally slow economy haven’t helped.
The average leasing volume for office spaces is around 33% below the pre-pandemic average. “Vacancy rates in the office sector continued to rise, as they were reported at 20.2% for the first quarter of 2024, up 160 basis points on a year-over-year basis,” Sharma explains. Funds from operations—a key metric for REITs—dropped the most in the office sector, and it currently sits at about 50% of its 10-year historical average. One thing is sure: New development projects and groundbreakings have seen a huge decline here, down by over 95% compared with 2019. Brown believes this trend will continue.
Top Picks
REIT Performance
Here are the metrics for Brown’s top picks, along with some of his commentary on them.
Kilroy Realty
- Fair Value Estimate: $59.00
- Morningstar Rating: 5 stars
- Economic Moat: None
- Morningstar Uncertainty Rating: High
- Forward Dividend Yield: 6.26%
- Price/Fair Value: 0.59
“Kilroy Realty shares have corrected by more than 55% since the onset of the pandemic, even as the company’s NOI has increased materially due to the completion of development properties and acquisitions. We recognize the uncertainty surrounding the future of office real estate and believe that the environment will remain challenging for office owners in the near to medium term. That said, we also believe the selloff has been overdone and the market is not recognizing the value of the company’s non-office-related assets and land bank. Kilroy has a high-quality portfolio with an average building age of 11 years, compared with 34 years for other office REIT peers. The company should be a prime beneficiary of the flight-to-quality trend in offices. Further, the company has a strong balance sheet with the lowest leverage within our office REIT coverage.”
Sun Communities
- Fair Value Estimate: $172.00
- Morningstar Rating: 4 stars
- Economic Moat: None
- Morningstar Uncertainty Rating: Medium
- Forward Dividend Yield: 3.07%
- Price/Fair Value: 0.71
“Sun Communities owns a portfolio of manufactured housing communities, recreational vehicle communities, and marinas in locations that are desirable as second homes or vacation properties. The company is down nearly 45% since the start of 2022, largely due to interest rate movements. Historically, the company has heavily relied on acquisitions for growth, making the company more sensitive to interest rate movements, though we don’t believe the volume of acquisitions significantly changes our fair value estimate for the company. Most of Sun’s segments have produced strong same-store NOI growth over the past five years with many nearing historical highs in 2023. However, the market seems focused on the transient recreational vehicle segment, which has declined over the past six quarters. Management continues to make progress in converting transient business into annual memberships, which produces more stable revenues and tends to have higher growth over the long term. We believe Sun will produce same-store NOI above the residential REIT average over the next several years, and that the market will recognize the strong internal growth story when interest rates stabilize.”
Ventas
- Fair Value Estimate: $69.00
- Morningstar Rating: 4 stars
- Economic Moat: None
- Morningstar Uncertainty Rating: Medium
- Forward Dividend Yield: 3.36%
- Price/Fair Value: 0.78
“Ventas’ portfolio of senior housing assets should produce double-digit net operating income growth for the next several years given strong demand growth combined with limited supply growth. Additionally, the company’s medical office and life science portfolios should provide recession-resistant revenue. The company’s development pipeline should also produce yields above the company’s cost of capital even in a higher interest rate environment, producing more cash flow growth for shareholders. Ventas sold off due to rising interest rates, but we believe this provides an attractive entry point for shareholders looking for a REIT with a strong growth story.”
Realty Income
- Fair Value Estimate: $75.00
- Morningstar Rating: 5 stars
- Economic Moat: None
- Morningstar Uncertainty Rating: Low
- Forward Dividend Yield: 5.51%
- Price/Fair Value: 0.76
“Realty Income’s portfolio should provide stable rental payments in nearly any economic environment. The company’s assets are mostly leased to defensive retail tenants like pharmacies and gas stations, which generally produce stable sales even in recessions. Additionally, the company’s high coverage ratio further helps the tenants maintain rent payments even if they experience a slowdown in sales. The company has sold off as it is one of the most sensitive names to rising interest rates given its high dividend payments and reliance on acquisitions for growth. However, we believe the current market-implied cap rate undervalues the company’s portfolio of stable assets.”
More About REIT Investing
Investors who’d like to extend their search for the best REITs can do the following:
- Review Morningstar’s comprehensive list of real estate stocks to investigate further.
- Use the Morningstar Investor screener to build a shortlist of REITs to research and watch.
- Read the latest news about notable REITs from Morningstar’s lead real estate analyst Kevin Brown.
The author or authors do not own shares in any securities mentioned in this article.Find out about Morningstar’s editorial policies.
