Real Estate Stocks Are on Sale
A steep slide in commercial real estate has put the sector on sale. Where to find 6% yields and growth.
Paul McDowell’s business has seen happier days. He runs Orion Office REIT, a real estate company that owns 81 office properties with an 88% occupancy rate. But hybrid work has hurt profits and demand for new offices. Since going public in late 2021, Orion’s stock is down 74%.
Paul McDowell’s business has seen happier days. He runs Orion Office REIT, a real estate company that owns 81 office properties with an 88% occupancy rate. But hybrid work has hurt profits and demand for new offices. Since going public in late 2021, Orion’s stock is down 74%.
“Being in the office sector is not necessarily the easiest place to be,” Orion’s (ticker: ONL) McDowell told a recent investing conference in New York, looking at his sparse audience.
The great debate in real estate is whether the vacant office buildings in many cities will ever refill. Office vacancy has reached nearly 25% in cities like San Francisco and Chicago. Office real estate stocks are down 50% from pre-Covid highs, while the REIT sector has lost 9.5% in the past year against the S&P 500’s 14.5% gain.
But offices are now just 3.4% of the $1 trillion public market for real estate investment trusts, or REITs. The broader REIT space isn’t as troubled. With valuations laid low, there are bargains amid the rubble.
Even the office space offers opportunities. Some Sunbelt and suburban areas are seeing healthy occupancy and rents. Office REITs, while troubled, are now deeply discounted. Hybrid work may be here to stay, but corporations are pushing workers to return. Recent data show job postings for remote jobs have flattened.
The selloff has delivered cheaper valuations and higher dividend yields. REITs, which must pay out almost all taxable profits as dividends, are yielding an average 4.1%, roughly double that of the S&P 500. After a large correction, REITs also look cheaper on measures of value such as the capitalization rate, or “cap rate”—which is like an earnings yield on rental properties. Cap rates now average nearly 7%, up from 5.5% before the pandemic, according to real estate analytics firm Green Street Advisors.
The sale prices reflect the fact that conditions aren’t yet favorable. A recession may lie ahead. The Federal Reserve hasn’t signaled that it’s done raising rates. And few of the bankers who make real estate loans are taking calls, frozen by higher rates, tighter lending standards, and loan-loss provisions—worries that the Fed highlighted in a recent report on financial stability.
“The most striking thing right now is the delta between fundamentals on the ground, which are pretty good, and lending conditions, which are pretty tight,” says Cedrik Lachance, research chief at Green Street Advisors. “Lenders don’t want to play ball right now.”
Yet real estate stocks are quite sensitive to economic data, reviving when leading indicators turn up. And compared with privately held real estate, which hasn’t corrected as much, the public market looks cheap, according to economist Ed Pierzak of the National Association of Real Estate Investment Trusts.
Real Estate on Sale
These companies are weathering the downturn and could be winners as conditions improve.
| Company / Ticker | Recent Price | YTD Return | Market Value (bil) | Forward 12-Month Price/FFO | Dividend Yield | Sector |
|---|---|---|---|---|---|---|
| AvalonBay Communities / AVB | $186.76 | 16.8% | $26.5 | 17.7 | 3.5% | Apartments |
| Equity Residential / EQR | 64.77 | 12.3 | 24.5 | 17.1 | 4.1 | Apartments |
| Digital Realty Trust / DLR | 109.59 | 11.8 | 32.6 | 16.3 | 4.5 | Data Centers |
| Equinix / EQIX | 769.20 | 18.6 | 71.9 | 35.0 | 1.8 | Data Centers |
| First Industrial Realty Trust / FR | 51.74 | 7.9 | 6.8 | 21.1 | 2.5 | Industrial |
| Simon Property Group / SPG | 112.79 | -0.9 | 36.9 | 9.4 | 6.6 | Malls |
| Healthpeak Properties / PEAK | 19.82 | -18.9 | 10.8 | 11.3 | 6.1 | Medical |
| Kimco Realty / KIM | 19.31 | -6.7 | 12.0 | 12.3 | 4.8 | Strip Centers |
| Cousins Properties / CUZ | 22.18 | -9.8 | 3.4 | 8.6 | 5.8 | Suburban Offices |
| Highwoods Properties / HIW | 23.31 | -13.2 | 2.5 | 6.2 | 8.6 | Suburban Offices |
FFO=funds from operations, a measure of cash flow commonly used to value REITs
Source: Bloomberg
At the start of 2023, cap rates for public REITs were more than 15% above private real estate, Pierzak says. REIT total returns also fell nearly 40% behind returns for privately owned properties from 2022 to 2023—the biggest divergence in four decades. Gaps of that magnitude tend to close within a year, as cap rates and returns converge, he says, providing a potential tailwind for REIT stocks.
Debt also looks manageable for publicly traded REITs. It averages 34% of assets, down from 65% during the 2008-09 financial crisis. About three-quarters of that debt is unsecured bonds or bank loans, leaving REITs largely free of mortgage obligations. And almost 90% of REIT debt is fixed-rate, maturing in an average of seven years. That gives some breathing room. All told, REIT balance sheets can weather today’s tight credit environment.
One optimist is Willy Walker, CEO of commercial real estate financing firm Walker & Dunlop (WD). The company has been hit hard; Wall Street sees its earnings per share at around $4.90 this year, down from a peak of $8.15 in 2021. But after a lean 2023, the Mortgage Bankers Association trade group expects a revival in loan originations next year. Walker notes that his company has not backed off its goal of increasing revenue 50% by 2025.
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