By Philip van Doorn
This guide highlights which real estate investment trusts are expected to generate the most cash for investors in 2023
With Federal Reserve Chairman Jerome Powell set to deliver an important speech Friday, investors may finally begin to take him at his word: The central bank is going to maintain a hawkish stance to control the highest inflation in four decades. This means financial markets will remain volatile, despite the recent stock market rally.
Read:Financial markets are bracing for what could be a ‘very hawkish’ Jackson Hole speech by the Fed’s Powell
There are many reasons to consider real estate investment trusts, or REITs, as relatively safe havens to provide steady income when inflation remains high and ahead of a likely economic slowdown.
Below is a screen of equity REITs expected to produce plenty of cash flow to enable dividend increases in 2023.
In the Need to Know column on Aug. 24, Steve Goldstein summarized predictions of a new "supercycle in inflation and interest rates" from Dario Perkins, managing director for global macro economics at TS Lombard.
Perkins expects long-term interest rates to keep moving higher, and suggests the 2020s will require investors to take "a more discerning approach to asset allocation."
Moving away from service providers that dominated the bull market through 2021, he believes what will work best is allocation to tangible assets, including real estate.
Breaking down the REIT sector
Real estate investment trusts come in many varieties, but the key element is they pass through most earnings to shareholders to maintain the tax-advantaged REIT structure.
There are two broad categories of REITs: Mortgage REITs, which lend money to commercial or residential borrowers and/or invest in mortgage-backed securities, and equity REITs, which own commercial or residential property and lease it out.
REITs are cyclical, with valuations pressured as interest rates rise. This effect can be especially pronounced for mortgage REITs, because the mortgage-lending business slows as interest rates rise.
So far this year, through Aug. 24, the S&P 500 real estate sector is down 15%, while the full S&P 500 is down 12%, both with dividends reinvested.
Taking a much longer-term look may surprise you. S&P Dow Jones Indices separated the real estate sector from the financial sector in 2016. But if we narrow down to the S&P 500 REIT industry group for a longer-term performance measure, the 20-year average annual return has been 9.9%, slightly ahead of the S&P 500’s 20-year average return of 9.8%.
REITs by category
Different types of REITs go through different economic cycles. For example, hotel REITs and their tenants suffered terribly in the early stages of the coronavirus pandemic, beginning with the virtual shutdown of the travel industry during the first half of 2020.
Many REITs are focused on the warehousing and logistics space, which has benefited from double-digit annual rent increases in recent years, according to Vikram Malhotra, a managing director for real estate at Mizuho.
But Amazon.com Inc. (AMZN) said in its first-quarter financial press release in April that after doubling the size of its fulfillment network in only two years, it was "no longer chasing physical or staffing capacity" and was "squarely focused on improving productivity and cost efficiencies" in its delivery infrastructure.
During an interview, Malhotra said that following Amazon’s announcement, he and colleagues had "observed and heard in the market that Amazon was putting warehouses on the sublet market."
"So the biggest player in e-commerce told the market it had too much and was rationalizing, and that caused the logistics stocks to de-rate," he said.
Prologis Inc. (PLD) is the largest publicly traded U.S. REIT in the warehouses and logistics space. The company listed Amazon, FedEx Corp. (FDX), Home Depot Inc. (HD), Geodis and Walmart Inc. (WMT) as its five largest customers at the end of 2021, with Amazon renting 24 million square feet, or 7% of its total.
Shares of Prologis were down 21% for 2022 through Aug. 24, with dividends reinvested. The stock’s dividend yield is about 2.5%. Prologis is set to acquire Duke Realty Corp. (DRE) through an all-stock deal valued at $26 billion when it was announced in June.
Mizuho has a neutral rating on Prologis, which Malhotra said was "out of consensus." It sure is — among 17 analysts polled by FactSet, 13 rate the shares a "buy" or the equivalent. The rest are neutral ratings.
He went on to say that Mizuho is monitoring third-party logistics operators, such as XPO Logistics Inc. (XPO), FedEx and United Parcel Service Inc. (UPS) for signs of slowing demand if the economy downshifts significantly.
With all that said, there may be a silver lining for the warehouse/logistics REITs: Malhotra expects rent growth in the space to slow to the "mid to high single digits" from the current range above 10%. The Labor Department said that the Consumer Price Index in July showed an 8.5% increase from a year earlier. That was improved from 9.1% in the previous month. It may not be too much of a stretch to expect REIT warehouse operators to be able to keep their rents increasing to match or beat the pace of inflation.
This is where your own opinion comes into play, based on your own research. Will the continuing trend toward online shopping and demand for quick delivery enable Prologis and its competitors to outperform over the next five to 10 years? Prologis’ five-year total return though Aug. 24 was 138% (compared with 85% for the S&P 500), even with this year’s big pullback.
Screening the equity REITs
To take a broad look at U.S.-listed real-estate investment trusts, we started with the 185 included in the Russell 3000 Index . This index represents about 98% of U.S. stocks, according to FactSet.
We then looked at the investment concentrations of each REIT and removed all the mortgage REITs to bring the list down to 158 companies. We cut further to 112 companies for which consensus estimates were available among at least five analysts polled by FactSet for adjusted funds from operations in 2023.
A way to measure a company’s dividend-paying ability is to look at its estimated free cash flow — remaining cash flow after expected capital expenditures. For REITs, funds from operations (FFO) — a non-GAAP measure — is commonly used. FFO adds amortization and depreciation (noncash items) back to earnings, while excluding gains on the sale of property. Adjusted funds from operations (AFFO) goes further, netting out expected capital expenditures to maintain the quality of property investments.
If we divide a company’s estimated AFFO by its current share price, we have an estimated AFFO yield. This can be compared with the current dividend yield to see if there is "headroom" for further increases — hopefully plenty of headroom.
Among the 112 remaining REITs, 104 pay dividends and have estimated 2023 headroom of at least 1.00% — that is our final cut.
We placed the 104 REITs into eight broad categories. This isn’t always easy, because a REIT may be highly diversified. So the categories are an attempt to place each REIT in a group according to its heaviest business concentration. We then consolidated a bit further to nine broad categories and sorted them by expected 2023 AFFO yield.
For example, the warehousing/logistics companies are in the "industrial" category. We’ll begin with that one.
Industrial REITs
Here are the 10 industrial REITs that passed the screen, with the highest expected AFFO yields for 2023:
Click on the tickers for more about each company, including business profiles. Then read Tomi Kilgore’s detailed guide to the wealth of information available for free on MarketWatch quote pages.
Health care
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