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Real estate investment trusts (REITs), publicly-traded companies that primarily own rent-producing properties, have broadly produced lackluster returns over the past 12 months. While the S&P500 has generated a total return (price plus dividends) of 17.9%, REITs1 have returned only 0.21%. Excluding dividends, REITs produced a loss, returning ‑3.6%. What’s going on?
We think that at least three factors are contributing to the unimpressive performance. Concerns about rising interest rates make the higher yields on REITs somewhat less attractive. Also weighing on returns: rising valuations and slowing earnings growth in most property categories, especially when compared to the open-ended growth potential of technology stocks.
Not all REITs have performed poorly, however. Those focusing on data centers (which serve the rapidly-growing cloud computing industry) returned over 20%, while many shopping mall REITs have lost upwards of 20% as they are under pressure from intensifying internet-based competition, which we call “Amazon Fever.”
As turnaround investors, we approach REITs differently: Rather than focusing on a particular segment of the real estate market, we look for individual REITs that have been neglected by investors but have solid value – that should prevail regardless of the overall market. Some examples, described in our May 2016 Turnaround Letter, include the following:
Note: Price change and total returns are measured from the May 27, 2016 article through June 30, 2017.
These REITs were out-of-favor but offered bargain valuations combined with catalysts for improvement. Over time, we have found that this approach can produce much better returns than the sector benchmarks.
For the REIT group in general, our outlook is much the same as their recent performance: lackluster. Price returns have a good chance of remaining flat, even though high dividend yields will boost overall returns. Valuations look stretched in most segments, and investors may continue to sell shares of REITs subject to internet competition. Broad economic growth is healthy but appears to have reached its limit and may be slowing down. With the Fed ready to start shrinking its swollen balance sheet and gradually increase interest rates, REITs will probably continue to struggle.
There are some attractive opportunities, however – we continue to like the prospects for the six companies highlighted above. In real estate, the mantra is often “location, location, location.” However, in REIT turnarounds, it’s “management, management, management.” Because REIT turnarounds often involve selling illiquid real estate, they can be measured in years, not months. However, for patient investors, they can offer substantial gains while often paying attractive dividends in the meantime. These six REITs have strong management teams and good strategies. Combined with attractive valuations, they offer the prospect of higher earnings and share prices even in a flattish overall REIT market.
1. As measured by the Dow Jones U.S. Real Estate index.