Market Insights

Should I Invest in a Real Estate Investment Trust?

August 15, 2022

By Daniel Keller, Summer Intern

How can a real estate company that operates in an inflationary market turn a profit? Interest rates and inflation are high, accompanied by two quarters of negative GDP growth. On one hand, companies have less cash on hand as increased operating costs crunch margins. New development and construction of property are hurting as we see a second consecutive quarter of negative GDP growth. On the other hand, higher interest rates have created a highly competitive residential rental market since fewer buyers can qualify for a mortgage or afford property. One way to make money in a rough commercial real estate market is by carefully selecting real estate investment trusts (REITs) in which to invest.

REITs are publicly traded companies that own and often operate income-producing real estate. Equity REITs own commercial real estate, including office and apartment buildings, warehouses, hospitals, shopping centers, hotels, and commercial forests. Mortgage REITs (mREITs) finance real estate by purchasing or originating mortgages or mortgage-backed securities. mREITs make money on the interest from those investments, providing liquidity critical to a healthy real estate market.
The COVID-19 pandemic forced many REITs to cut dividends. Most of the cuts were by retail REITs that own shopping centers and hotels. Since the pandemic, dividends have recovered, and REITs have enhanced their balance sheets to protect against future rainy days.

Today, like during the pandemic, the specific industry REITs cater to largely determines their success. Investors are wary about industrial REITs because of the adverse effects of depressed consumer spending on the e-commerce industry. Additionally, the remote work movement is hurting many office REITs. Typically, the value of the property owned by all REITs increases with higher inflation rates. At heart, the long-term value of a REIT depends on which industry it serves. Selecting a REIT with long-term value is essential to finding stable dividends and stock prices.

Investors generally view REITs as low-risk investments with stable dividend payments. They are low risk because their primary source of revenue is rent. REITs with financially stable tenants have predictable income. In addition, leases contractually promise future revenue and decrease the volatility of profit margins for REITs. REITs have a unique structure requiring them to pay out 90% of their taxable income to their shareholders. High dividends and low risk make REITs attractive for income or value-based investors who like stocks with a low beta value and a high dividend yield. Three REIT sectors currently well-positioned to complement a long-term, income-based portfolio are industrial, infrastructure, and healthcare.

Industrial REITs have sustained demand from e-commerce growth and increasingly complex shipping logistics. Prologis (PLD) is a global logistics REIT that owns the most industrial real estate out of any company in the world. They own 4,675 industrial properties, totaling more than 1 billion square feet of leasing space in 19 countries. Most of their properties are in supply chain centers, including North America, South America, Europe, and Asia. They boast a 98% occupancy rate with a 75% retention rate. Prologis is not faltering from competition anytime soon as it would be nearly impossible for another company to recreate their logistics and warehouse systems from scratch. Prologis has been growing for years. Most of its tenants are in retail fulfillment or conduct business-to-business transactions. Prologis' largest tenants are Amazon, Geodis, FedEx, DHL, and Home Depot. Recently, Amazon announced that they over-expanded during the pandemic and plan to cut warehouse space. The decision is meant to improve margins by lowering storage costs for its e-commerce business. It announced the news amidst supply chain issues that caused companies to rely more heavily on warehouse space for reserve inventory. The company's choice is not indicative of a widespread slowdown in e-commerce growth. A shift from brick-and-mortar retail to direct-to-consumer sales will drive future e-commerce growth. Looking forward, Prologis has exciting projects that bode well for earnings. Its primary source of value is its massive portfolio and a strong pipeline for new property and tenants. The company started over $1 billion worth of development projects during the March quarter. Its potential buildout based on owned land is estimated to be worth about $28 billion. Furthermore, the recent acquisition of Duke Realty (DRE) is the largest real estate deal since the start of the pandemic. Duke Realty owns 160 million square feet of warehouse space in Southern California, New Jersey, South Florida, Chicago, Dallas, and Atlanta, a significant addition to Prologis' vast portfolio. Prologis expects to close the deal in December as both boards have already approved it.

The company has about $7 billion in liquidity and $18 billion accessible to fund new acquisitions and development. Its debt (mrq) to EBITDA ratio is 4.84, revealing Prologis' large cash inflow and ability to pay off its debt rather quickly, a vital characteristic for a REIT. REITs operate with relatively high debt levels because they own mortgages on many properties. They keep limited cash on hand because their margins are high and revenue is predictable. A strong pipeline, reputation, portfolio, and balance sheet put Prologis in a position to grow dividends over the next few years. The current dividend yield is about 2.48%, $0.79 per share. It has increased its annual payout by 11% year over year in the last ten years. Prologis raised dividends by 25% this February, perfect for a long-term income investor.

Like industrial REITs, infrastructure REITs offer secular growth, stability, and rich dividends. Crown Castle International (CCI) is an infrastructure REIT that owns and provides telecommunications providers with access to approximately 40,000 telecommunications towers in the U.S., 80,000 route miles of fiber assets, and 115,000 small cell nodes that are active or in development. Telecommunications companies use small cell nodes to improve cellular connectivity on new 5G networks. They are smaller and more discreet than cell towers, but more are needed to strengthen coverage where devices would otherwise compete for a signal. Fiber is also essential for the next-generation telecommunications technology--5G. Crown Castle owns technology important for telecommunications providers to expand into next-generation, high-speed networks. Crown Castle's top customers have plans to improve cell signal using 5G and are already advertising it to consumers.

Crown Castle is solely focused on U.S. telecommunications as it sold all its international assets in 2015. Over the past ten years, the company has spent $20 billion on tower and fiber acquisitions. They also invested $11 billion to build more towers and fiber assets. Crown Castle plans to continue another decade-long investment cycle as its customers expand into next-generation wireless networks. American telecommunications providers are increasing their capital expenditure to enhance their networks, relying on companies like Crown Castle for cellular towers and fiber assets. Crown Castle's largest tenants by rental revenue include T-Mobile (37%), AT&T (19%), and Verizon (19%). Shares of Crown Castle are down about 17% year-to-date, slightly outperforming the S&P 500. Essential nationwide infrastructure protects from market swings, reflected by the stock's low beta value of 0.75. A management team that plans to acquire more technology aims to ensure the company's assets will be sufficient to meet demand. Crown Castle also benefits from long-weighted average remaining lease terms and rent escalation provisions, indicating robust future cash flows from tenants. Furthermore, rent escalation provisions allow REITs to maintain profits during inflationary periods, contributing to the stock's low-risk profile. Strong demand for cell towers and fiber routes, plans for new acquisitions, and favorable lease dynamics will support future revenue growth for Crown Castle. The company's current dividend yield is 3.36%, $1.47 per share. In the following years, the company expects to grow dividend yield by 7% to 8% annually, with adjusted funds from operations (FFO) estimated to grow at a double-digit annual clip. It has a healthy balance sheet with a debt (mrq) to EBITDA ratio of 4.8x, which is lower than the prior-year quarter.

Why invest in Crown Castle over a more established player such as American Tower? Both companies have approximately 40,000 U.S. towers and near equal returns. Unbeknownst by its name, American Tower owns cell towers in 25 countries. Unlike Crown Castle, it is focused on traditional cell towers. Crown Castle is a comprehensive telecommunications REIT as it owns not just towers but also fiber routes and small cell nodes. Although cell towers are critical to expanding next-generation communication, they only fill a portion of the puzzle that Crown Castle plans to solve on its own. Ultimately, Crown Castle's stability and strong dividend yields make it attractive for long-term investors seeking companies with untapped value.

Alexandria Real Estate Equities (ARE) is a type of office REIT with immense potential for growth because of its innovative development approach and relationship with the life sciences industry. It owns property in San Francisco, San Diego, New York City, Boston, Seattle, Maryland, and North Carolina's research triangle. Alexandria's office/laboratory space hosts life sciences, agricultural technology, and technology tenants. The company specializes in "collaborative space," differentiating itself from other office REITs. Compared to a traditional office REIT renting to financial or law firms, renting to life science businesses provides a moat around the remote work movement. Much of Alexandria's tenants' work, such as biotech research, cannot happen at home.

The life sciences sector, Alexandria's specialty, has boomed during the pandemic with increasing research and design for diagnostic tests, therapeutics, and vaccines. The pandemic fueled lab space demand, boosting occupancy and rental rates. Accordingly, increased profits allowed Alexandria to expand its portfolio. In 2021, it recorded the highest annual leasing volume in company history, collecting $6 billion in contractual triple-net base rents. Alexandria's relationship with Moderna Inc. (MRNA) generated over 1 million rented square feet (rsf) of real estate in 2021. 462,000 rsf came from the construction of Moderna's headquarters in Cambridge, Massachusetts, while the remaining 684,000 rsf was from long-term lease renewals at three existing Moderna locations. Strong connections with leaders in the life science industry will fuel future demand. Alexandria is 28 years old and has established itself as a lessor to companies in the life science industry. In addition, a booming biotech industry will help demand. Of over 10,000 diseases known to humans, only 10% are currently addressable with therapy. Experts refer to the current era as the "new golden age of biology," creating historical demand for lab space. The company has a value-creation pipeline of 7.4 million rsf. The value-creation pipeline includes projects that are currently under construction or expected to begin within the next six fiscal quarters. 83% of the 7.4 million rsf pipeline is already leased or amid lease negotiation. Furthermore, 94% of leasing activity comes from existing relationships, showing the company's tenants are loyal and trust Alexandria to provide high-quality facilities.

Alexandria relies on Harvard business professor Michael Porter's cluster theory, unlike other REITs that cater to the life sciences sector. According to his theory, concentrating industries in a particular region is conducive to success for companies in the area. Alexandria believes location, innovation, talent, and capital are essential components of a thriving life science company. As opposed to limiting itself to a single asset, Alexandria and its tenants prefer "amenity-rich cluster campuses" that maximize employee productivity and work efficiency. Alexandria has a price-to-earnings ratio of about 55, as sizable investments in construction and the development of new property are hurting Alexandria's earnings. The company's balance sheet is decent, with a debt (mrq) to EBITDA ratio of 7.08. It has a dividend yield of 2.90%, which is expected to grow in following years as they expand their portfolio. Alexandria is more than capable of paying off its debt, but that is not its focus in the years to come. Alexandria plans to continue building and developing property, as indicated by its large pipeline, mainly composed of underway and future construction projects. Alexandria's focus on long-term growth provides stability for investors looking for steady dividends and secular growth drivers.

In a tumultuous economy, investors often seek refuge in hard assets. Hard assets prevail during recessions since their value is intrinsic and not heavily influenced by market conditions. REITs are a blend between an operating business and an investment in hard assets. Investors harvest the profits made by REITs, through operating and strategically leasing property, to affordably invest in the underlying assets of a REIT -- real estate. Investing in REITs makes it easier to put money in hard assets without actually buying individual properties.

Relying on time-tested philosophy is vital to making smart investment decisions. How did individuals make money during the gold rush? It was not by mining gold; the success rate was too low. People made money by selling products to the gold miners, insulating them from the risk inside the gold mines. Investors can apply the same logic to REITs during a recession. REITs capture profits from many companies within the same industry. This provides lower risk compared to investing in individual companies. Prologis, Crown Castle, and Alexandria all participate in industries expected to grow long-term, namely e-commerce, telecommunications, and life sciences. Tenants with growing profits are essential for a REIT to collect rent and maintain a healthy balance sheet. It is possible to find stability in REITs by paying close attention to long-term value. Instead of speculating whether market conditions, remote work, or reduced hiring by technology companies will hurt REITs, it is more helpful to look for companies with secular growth drivers.

linkedin facebook pinterest youtube rss twitter instagram facebook-blank rss-blank linkedin-blank pinterest youtube twitter instagram