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Investors in real estate investment trusts (REITs) have been hit hard as the Federal Reserve has aggressively raised interest rates. REITs invest in real estate, lease it to tenants and trade on the stock market like a stock. They’re a favorite with investors because of their high dividends and strong record of growth.
The Vanguard Real Estate Index Fund ETF was pummeled in 2022, even more so than the Standard & Poor’s 500, whereas it’s typically less volatile. This underperformance may be surprising, too, since this index has often outperformed the S&P 500 over long periods.
With rates rising so quickly, the basic building block of REITs – money – is becoming more and more expensive. Not only that, but rising rates hurt the value of REITs’ real estate, and factoring in REITs’ debt, falling property values can swing the net asset value of a REIT even faster.
While the thought of selling your REITs may feel good at the moment, this approach could cost you dearly in the long term, making the situation even worse than it already is. REIT investors should try to avoid these common mistakes and keep their portfolios protected from the downturn in the economy.
1. Selling at the bottom
Investing is all about buying low and selling higher. So when the market drops substantially, as it has done in 2022, you want to evaluate whether you’re selling only because the REIT has gone down or because you think it’s going to fall further due to fundamentals.
A REIT stock price builds in the expectations of potentially millions of investors, who are looking at all kinds of data (vacancies, economic growth, tenant problems and many more) to determine their best guess at the value of the business. While the price can always move later, it often takes new information to shift investors’ view of the REIT.
The market is often effective at predicting the future. Good news can happen without you being aware of it, and often the good news can be attributed to investors becoming less pessimistic overall. If the situation changes in a favorable way, REIT values could actually go up, not down, leaving you having sold near the bottom, despite what seems like a miserable economy.
2. Not analyzing a REIT carefully
Whatever you’re thinking about doing with a REIT – buying, selling, or standing pat – it’s important to analyze them and the industry carefully. REITs operate in many different sectors — healthcare, lodging, apartments, retail and data centers, to name a few. The dynamics of each of these sectors is tremendously different, so you can’t take a “one size fits all” approach.
For example, data center REITs and tower REITs may hold up reasonably well, while lodging and retail REITs may reel during a slowing economy. Even healthcare REITs, which usually enjoy consistent demand, may be hit harder than you expect. So you’ll have to understand the dynamics of each sector.
Before you make a decision on how to proceed, consider these factors as well as the more specific situation at each company. Are tenants paying their rent? Is the debt load manageable? Will the company need to raise money in the future if the economy doesn’t improve? Will the REIT – such as an owner of theaters – fare well in a “new normal” economy?
Of course, those are just a few of the questions that you’ll want to consider before taking any action. Let the facts guide your decisions and not the other way around.
3. Letting fear keep you from buying good REITs
If you’ve analyzed the company and the long-term future looks good, it could be a mistake not to buy more, especially if you’re receiving a significant discount to what you think the REIT will be worth in the future. So it’s important not to let fear scare you away from a good bargain.
That’s not to say that every discounted REIT is a bargain. And even good companies can become cheaper as new information emerges or investors become more pessimistic. That’s one reason why many experts recommend using dollar cost averaging to buy into stocks. Using this approach, you can spread your buying apart to average into a stock.
While REITs are known for their stable dividends, if a REIT isn’t collecting its rent, it will have a hard time paying its dividend. So investors may already be pricing in a lot of potential for a dividend cut. But if that dividend cut doesn’t happen, the stock may be primed to bounce higher.
If the REIT’s fundamentals look good and it can continue growing in the future, but it’s not priced for this scenario, then it might be a good time to pick up shares. But often you’ll have to overcome your fear. Doing a thorough analysis of a REIT can help you eliminate any doubts.
4. Only concentrating positions, not diversifying
If you’re looking to buy REITs in the downturn, it can be a mistake to focus only on the ones you own. Instead, it could be an opportunity to buy some of the high-performing stocks that simply looked too expensive before. In this way, you can take advantage of the power of diversification, actually adding more high-quality companies to your portfolio, while they’re relatively cheaper.
For example, the growing digital economy has been great for some REIT sectors in the last few years – warehouses, data centers and telecom towers, especially. While many of these sectors have held up well, they’re still below their 52-week highs. But the outlook for these sectors over the long term remains strong.
By diversifying, you can reduce your portfolio risk while potentially adding some high-quality gems. It also helps balance the risk of one blowing up, given the significant debt that is common for REITs.
5. Assuming things will return to normal quickly
With the Fed still actively raising interest rates, it could be a mistake to think that the stock market will bounce back any time soon. Experts still believe the central bank will continue hiking rates for a while yet, as inflation remains robust. So this environment will make it difficult for even great companies to snap back quickly.
On top of this issue, REITs are typically financed with significant debt, in the same way that homeowners typically borrow a lot to finance their homes. As rates rise and debts roll over, many REITs will have to refinance with more expensive money, lowering their profit.
While REITs as a whole will likely do fine longer term, it could be a mistake to expect business as usual too soon. That’s another reason why dollar cost averaging could be a good strategy.
REITs offer an attractive way to invest in real estate for the long term, but investors need to tread carefully during this downturn, negotiating the path between careless optimism and myopic pessimism. The market’s slide could offer significant value to set your portfolio up for decades of great returns, including a growing stream of dividends. But you’ll want to balance this upside against the potential for loss, especially if the economy weakens further from here.