REITs have many subcategories.
Owning real estate is a way to hedge against inflation while still getting solid returns in a volatile market, and real estate investment trusts offer investors that exposure without the burden of managing property directly. According to a recent LendEDU survey, 13.5 percent of Americans chose real estate as their top investment choice, and 29 percent said they wanted to invest specifically through a REIT. But REITs are a diverse bunch, with multiple subcategories that concentrate their investments in different kinds of real estate, each with distinct advantages and risks. What follows are the best REIT categories to invest in now, along with any potential threats to keep an eye on.
Aging populations favor health care.
Thanks to aging populations, health care REITs have a favorable long-term outlook. Besides hospitals and medical office buildings, health care REITs also invest in senior living and skilled nursing facilities, both facing rising demand. Recent health care reforms, however, may challenge the short-term profitability of nursing care facilities, resulting in tenant credit issues, says Milena Petrova, associate professor of finance at Syracuse University’s Whitman School of Management. “Investors should focus on REITs investing in medical office buildings and hospitals, as opposed to those with more exposure to skilled-nursing operators,” Petrova says.
These residential REITs are attractive now.
Historically, residential real estate has been a strong performer. The new tax laws that eliminate most of the tax advantages of home ownership, along with millennials favoring renting over buying, make residential REITs that invest in multifamily properties particularly attractive now, says Yuen Yung, CEO of Casoro Capital. What could rain on that parade? “Rising interest rates will squeeze the profit margins of REITs unless the increase in interest cost can be passed on to residents,” Yung says. In markets where rents have been rising steadily, there may not be much room to push those costs onto renters, he says.
Mortgage REITs perform best in a flat market.
Interest rates also affect mortgage REITs but typically to a lesser degree. These REITs invest mostly in mortgage loans and mortgage-backed securities. “There’s a misperception that mortgage REITs trade based on interest rates,” says Jesse Stein, chief investment officer of Compound Asset Management. “Most of them are appropriately hedged so changes in interest rates [aren’t] the primary risk — it’s rising defaults.” Mortgage REITs perform best in a flat market. “If you have a strong bearish or bullish view on the market, you should reduce your allocation to mortgage REITs,” he says. Petrova cautions that mortgage REITs, with their significantly higher leverage, are better for risk-tolerant investors.
Grocery-anchored retail is a bright spot.
While many retailers struggle, grocery stores and grocery-anchored retail REITs continue delivering positive returns. “Though large cities have seen a rise in online grocery shopping, grocery-focused retail centers still anchor towns in primary and secondary markets,” says Jeff Edison, CEO and president of Phillips Edison & Co. “These properties offer local communities goods and services that can’t be found online.” For instance, grocery centers often house non-retail tenants, such as services, fitness and medical businesses. That allows grocery-anchored shopping centers to be more resilient than other REIT properties, says Michael Carroll, CEO of ShopOne Centers REIT.
Data centers are highly profitable.
Cloud computing and big data analysis are pushing data center REITs into the spotlight. Capital spending from cloud service providers continues to balloon and should accelerate in 2018, says Beth Mallette, a senior analyst for Manning & Napier. The result: outsized demand growth for data centers, which are highly profitable for REITs because they generate unlevered returns that exceed the capital cost, she says. These REITs also have similar demand drivers as tech stocks, along with attractive dividend yields. That’s a plus, considering that many top tech stocks don’t offer a dividend. Still, “added interest rate sensitivity with data center REITs, relative to tech stocks, is something to be mindful of,” Mallette says.
E-commerce propels industrial properties.
Last year industrial REITs, which invest in warehouses, distribution centers and storage facilities, returned a total of 20.58 percent, according to the National Association of Real Estate Investment Trusts. For that, the REITs have online shopping to thank. “We’ve seen tremendous demand for warehouse space as e-commerce is finally large enough to really move the needle in terms of incremental demand,” Mallette says. “As a result, occupancies are near record-high levels, rent growth has continued to surprise to the upside, and new supply continues to be quickly absorbed.” The biggest threat is a potential trade war that could disrupt supply chains and dent profits for industrial REITs.
Timber REITs are a good way to diversify.
Timber REITs aren’t only a hedge against inflation but also offer low correlation to the stock market. Forestland is a limited natural resource, and timber supplies can’t be increased easily. Mallette says now is an interesting time to own timber REITs “given the combination of attractive supply and demand drivers that we think will be supportive of a pricing recovery in southern U.S. sawlog prices.” One possible drawback for timber REITs is their significant exposure to sawmills and paper mills. A reduced demand from those industries or a natural disaster that shrinks timber supplies could have negative ripple effects for REIT investors.
Hotel REITs are sensitive to market conditions.
Just as hotel and resort properties range from luxurious to budget-friendly, lodging REITs can be distinguished by the type of guests they serve. The major selling point of these REITs is their higher dividend yields, which hover “around 6 percent, versus 3.9 percent for all equity REITs and 1.9 percent for the Standard & Poor’s 500 index,” Petrova says. Lodging REITs, though, are sensitive to market conditions and tend to have “the highest correlation to the broad stock market compared to all other REIT classes.” In other words, “ignore the fact that they’re real estate companies,” Stein says. “Returns will be determined by the underlying product, not the performance of the real estate.”
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