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John Worth is executive vice president for research and investor outreach at Nareit, the national association of real estate investment trusts. Motley Fool analyst Deidre Woollard and Motley Fool contributor Matt Frankel caught up with Worth to talk about topics including:
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This video was recorded on September 25, 2022.
John Worth: One of the things we’ve seen is that as rates have risen, we’ve seen REITs really actually reduce the amount of debt they’re issuing at because they don’t have a lot of debt coming due immediately. They’ve got a lot of flexibility to deal with a higher-rate environment.
Chris Hill: I’m Chris Hill, and that’s John Worth, Executive Vice President for Research and Investor Outreach for Nareit, the national association of real estate investment trusts. Deidre Woollard and Matt Frankel caught up with Worth to talk about how REITs are feeling the effects of rising interest rates. Why more of them could be taken private, and which sectors are showing some promise in a challenging environment.
Deidre Woollard: We’re long-term investors here, but we’re reaching the end of another earnings season. Was there anything in this quarter that surprised you about overall REIT performance?
John Worth: I think I wouldn’t necessarily say it’s a surprise, but we’ve seen this consistent, strong operational performance where REITs are delivering earnings. For the second quarter, REITs had total FFO, which is the REIT measure of earnings funds from operation. They had total FFO of over $19 billion. That was a record high. Virtually, all of the sectors of the REIT space, and we could talk a little bit about the diversity of property sectors within REITs later, but most of them now have total FFO that’s above their pre-COVID levels. We’ve really seen a very significant recovery from COVID. Frankly, that operational performance, I think if there’s anything that’s a surprise, really, we’ve seen this gap between the strong operational performance. In a year like most equities, it’s been a tough year for REITs. REITs are down about 12 percent for the year. There’s really a divide between what we’re seeing coming through the earnings statements and again, how REITs are getting valued in the stock market today.
Matt Frankel: You mentioned the COVID pandemic and I want to expand on that a little bit. We’ve seen the stock market, as you said, is been on a downtrend lately. The short way to say what you just said is that the business results don’t always match the stock price performance and that’s what we’re seeing in the real estate. COVID affected real estate subsectors in a lot of different ways. Demand for industrial properties is off the chart because of e-commerce. Some other ones like retail had to shut down for a while because of COVID. What do you think are the lasting effects of the COVID pandemic on the real estate space as opposed to the temporary effects like the retail shutdowns?
John Worth: I think there’s going to be a couple of lasting effects. One, I’m not sure if it’s an effect, but I put it down under lessons is really the critical role of having a well-diversified portfolio of real estate. As you mentioned, we had some sectors that were really hard hit at the beginning of the pandemic as we were essentially shutting down a lot of in-person activity in the economy. Hotels and leisure, retail, healthcare was hard hit obviously. But we had other sectors. Industrial and logistics properties which are participating in e-commerce, data centers, cellphone towers, and interestingly, self-storage that really, we’re picking up some of that activity as parts of the economy we’re shutting down and we were increasingly living digital lives in our homes.
That was actually encouraging the use of other types of real estate. I think one lesson is, it’s really important to have a broad-based portfolio of commercial real estate, and one that really maps to what the economy is today, that embraces the digital aspects of our economy today. That’s one of the things where REITs have really been on the front and have been leaders in terms of innovating in data centers, cellphone towers, integrated logistics centers. As we look forward, I think how our lives going to change permanently because of COVID, I think the most obvious is the role of the office in our lives and the impact of work-from-home. As people, I think at least for the near term, we’re going to continue to see a lot of experimentation around how people use offices.
Ultimately, it’s an open question how that’s going to impact demand or how negatively it’s going to impact demand over the long term. We’re also going to see some sectors like retail that originally were really hard hit. But over the longer term, what we’ve really seen is more innovation into multi-channel shopping and I think it embrace by consumers of a shop here, buy online, pickup in-store, and that true integration of online and the retail shopping experience. The last piece is just, I think we did see a jump ahead in terms of our digital lives, the increased use of video conferencing. We’ve got my 80-year-old mother doing Zoom calls all the time. I never would have predicted that three years ago. It’s become part and parcel of daily life. All of that activity actually resides in real estate. I’d say those are some of the key takeaways.
Deidre Woollard: Interesting. One of the things that I love that Nareit puts out is that pie chart that’s got all of the different types of REITs as they changed from 10 years ago to now, it’s fascinating to see how everything’s changing. I wanted to ask you about the two Is that are troubling consumers right now, we’ve got inflation and interest rates. We are seeing that impact really heavily on the residential side. What are you seeing on the commercial end of things?
John Worth: Well, I think that certainly in Q2 earnings, we saw REIT earnings keep up and we saw REIT net operating income, the measure of the revenues that they’re bringing in through their properties. Net operating income actually grew on a year-on-year basis faster than the rate of inflation. Even on a same-store basis where we hold the number of properties constant, almost kept up with the rate of inflation. That’s really important because one of the ways that real estate has historically provided inflation protection is by having the ability to pass through increases and pass the rent increases that allow total revenue to rise as fast or faster than the rate of inflation. We think the evidence is pretty good that, in previous inflation cycles, REITs are going to provide good inflation protection in this cycle. We’ve gone back and looked at the historic data. Historically, REITs, like other types of real estate, do provide some nice Inflation Protection and tend to meaningfully outperform the broader stock market during periods of moderate and high inflation.
I think the operational performance suggests that we’ll see the same in this cycle. Then on interest rates, higher interest rates are not going to be good for any part of the economy. I think we’ve got a real risk of an economic slowdown. But in terms of how the higher interest rates are going to impact REITs directly, they’re in a very good place in terms of how they’ve managed their balance sheets. They’re coming into this rate-tightening cycle with leverage near historic lows, with interest expense at historic lows, and with the debt they do have very well termed out on their balance sheets. The term structure of that debt is out more than seven years now. One of the things we’ve seen is that as rates have risen, we’ve seen REITs really actually reduce the amount of debt they’re issuing at because they don’t have a lot of debt coming due immediately. They’ve got a lot of flexibility to deal with a higher rate environment.
Matt Frankel: One thing I wanted to ask is, this is not a normal market environment right now. I don’t really know when it is a normal market environment or if there is such a thing. We always say, well, it’s off just normal environment or just the normal recession or just the normal bull market. But what subsectors are really the big performers right now and what has really surprised you? For example, I read some of the industrial REITs earnings reports and they’re getting something like 20 percent releasing spreads, which is just unprecedented. The successive industrial, even though it’s a natural fit for e-commerce and natural catalyst has really surprised me. Has anything in the real estate industry really surprised you over the past year or so?
John Worth: I wanted to say one of the big surprises over the entirety of the COVID period to me has been the fact that if you look and you ask, what is the sector with the best stock market performance over the entirety of the COVID period really from early March 2020 through today, and it’s actually self-storage. I think it shows in a way how the consumers are in some ways, always a step ahead of the analysts. We understood going into COVID, retail was going to suffer, healthcare was going to sell through, this wasn’t going to be good for hotels. We thought it was going to be good for the digital sectors. But the impact on self-storage was really the second-order effect. As people started spending more time in their homes, cleaning out the garage, teaching their kids in their basement, all the things we went through. They needed to use that real estate in a different way.
That required them to go use self-storage to house some of their belongings. But the persistence has been really strong and self-storage actually had very strong FFO growth in the second quarter. Self storage, I think has been one of those really interesting stories. I think some of the other surprises, I would say was across the board. I was a little bit surprised about the Q2 earnings, the degree to which REIT acquisitions actually held up. In a higher rate environment, we knew transactions in commercial real estate generally were falling. Buyers and sellers we’re really in a way, taking time to coalesce around some new equilibrium pricing and cap rates in a higher rate environment. We certainly saw REIT transactions volumes fall. But even with the current environment, we still saw that $18 billion in REIT transactions in the second quarter. Those transactions end up being driver of future earnings growth. It is good to see that hold up.
Deidre Woollard: I want to ask you about that because we have been noticing that M&A activity. M&A just got the Prologis and Duke Realty perspectives mail to me. You mentioned some of the factors that are driving this, but is it going to keep happening? Are we going to see more of these types of deals?
John Worth: Well, I think that over time we’re likely to continue to see deals of the type that I think Prologis and Duke is a good example. These are actually the majority of deals by deal volume over the last couple of years are transactions that are from retreat within the same property sector. So we’ve seen a number of deals where rates are focused on getting bigger, growing their operating platform, lowering costs, lowering their cost of capital, and really getting prepared for future growth by creating more size and scope. I do I think it’s one of the most interesting trends in REIT mergers and acquisitions.
My guess is it’s something that over time, when it’s strategically appropriate, we’ll see more of this. These are deals that are really, I think they’re not opportunistic, they’re strategic deals. But I do think we’ve seen these across a number of sectors. My guess is that over the coming years, we’re going to see more of this. Because as real estate modernizes, as you’re dealing with more real estate that is engaging with the modern digital economy. I think that the value of that operating platform and the ability for REITs to have world-class operating platforms that adds significant value to shareholders becomes a more and more important part of the business. Scale and scope really can help in that way.
Matt Frankel: I hope you’re right that we see more of that type of M&A. We’ve also seen a lot of REITs being taken private by private equity. A trend that I’m not personally a fan of because just today morning, American Campus Communities has recently taken private, and I would have rather had seen the next 10 years of that growth story play out rather than just get a little quick bump from the premium of the buyout. What’s fueling that trend is there just a lot of investor money sitting on the sidelines instead of a more attractive way to invest in real estate than just buying properties.
John Worth: Some of these deals they did not technically going private, they’re going into the non-listed REIT space. So those are still REITs that investors have access to. I think a lot of that activity, it is still in the public REITs space, but not, they’re not listed on the stock exchange. One of the things about REITs that I think has helped them really outperform over the long term out to be one of the, if not, the best performing vehicle for commercial real estate, has been the strong corporate governance and having shareholder control. One side of that coin is when there’s a bid out there, the leadership and the board has to respond to that. When a bid comes in, that values of REIT significantly above where they’re trading, they need to take a close look at that and do what’s in the shareholders best interests. I think that when you see these deals and virtually all of these deals that we’ve seen over the last couple of years have happened at very significant premiums to where the stock is trading. You really have to look at that and say, “Well, that’s what we expect from good corporate governance.”
Deidre Woollard: I always remind people that the Cloud isn’t in the Cloud, it’s in data centers. Many of the tech companies that we love, well, their REIT clients all over the place. If you could look into the future thinking about that pie chart, is there any sector that you think is small now that’s going to be really big?
John Worth: That’s a great question. I think that one of the sectors we’ve seen some growth in, that it’s not even an independent sector yet. There is specialty right now is gaming and leisure properties. Properties that are having triple-net leases with gaming companies. I think that’s an area where we’ll see continued growth. I think that we’re going to also see that the property sectors that we have continued to evolve. If you think about industrial, which is a traditional property sector. But what we call industrial properties today, which are really logistics facilities. They’re very different from the warehouses of 20 years ago. I think we’re going to see throughout our property sectors, continued innovation and change, and continued uptake of a lot of interest in PropTech. That is going to change the way the tenants interact with the property and continued to grow and evolve what we think of as real estate.
Matt Frankel: Really interesting to think of the future of real estate and what’s evolved. Just by looking back when you think, and you mentioned industrial. Today’s industrial properties don’t look anything like they used to. Even with malls, I would go so far as to say today’s malls, don’t look anything like the malls we’ve had 20, 30 years ago.
John Worth: Absolutely. It’s a totally different shopping experience today than when I was a teenager in New Jersey, going to the mall. It’s a totally different experience and even strip centers, grocery stores, big-box stores. The whole experience has changed through and continues to change because of multi-channel retailing.
Matt Frankel: Investors need to know that when things evolve, consumers demand different malls that creates opportunities for REITs to adapt to changing tastes.
John Worth: Absolutely. I think when you think about a property sector like an office where there’s a lot of uncertainty. That uncertainty is also an opportunity. When you get the model right, and you get the pricing right, that creates a real opportunity and a lot of upside potential.
Matt Frankel: What would you like people to know about REIT or REIT investing in general right now in 2022?
John Worth: I really finished where we started, which is we think, and there’s lot empirical evidence and data that suggests having real estate is part of a portfolio is absolutely critical. Commercial real estate represents about 15-20 percent of the investible universe in the United States. We’ve done a lot of portfolio optimization that actually suggest somewhere in that range is the exposure to commercial real estate that is appropriate at an optimal portfolio and REITs or the way that the vast majority of investors are actually getting that exposure in US. They’re really worth exploring and there’s a lot of different active and passive strategies to bring them into a portfolio.
Chris Hill: As always, people on the program may have interest in the stocks they talk about, and the Motley Fool may have formal recommendations for or against, so don’t buy or sell stocks based solely on what you hear. I’m Chris Hill. Thanks for listening. We’ll see you tomorrow.
Chris Hill has no position in any of the stocks mentioned. Deidre Woollard has positions in Prologis. Matthew Frankel, CFP® has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Prologis. The Motley Fool has a disclosure policy.
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