10 Most Undervalued REITs: Morningstar

Although real estate stocks have been up and down over the past year, investors can still find opportunities among undervalued, high-dividend-paying companies in the sector, Lauren Solberg, a data journalist at Morningstar, wrote in a recent blog post.

Real estate investment trusts had their best year in history during 2021. The Morningstar U.S. REIT Index surged 41.1%, and the Morningstar U.S. Real Estate Sector Index gained 38.3% — making real estate the second best performing sector in the U.S. stock market after energy, even topping the 33.9% gain in technology shares.

Then with the new year came interest rate hikes and fears of recession, and returns plummeted. At its worst levels, the Morningstar U.S. REIT Index was down 23.4% this year, according to Solberg.

Over the past 12 months, the Morningstar U.S. REIT Index fell 4.4%, better than the broader market’s loss of 7.6% for the same period.

There is some good news in this for investors looking to put cash to work: Thanks to their steep share-price declines, many of these high-yielding stocks are now trading at big discounts compared with where Morningstar’s equity analysts peg their fair value.

REITs’ Value-Add

REITs, which own portfolios of properties that generate income from rent and capital appreciation, are required to pay out at least 90% of that income to investors in the form of dividends, making them an attractive play for income-focused investors.

The Morningstar U.S. REIT Index carries a trailing 12-month dividend yield of 3%, which is double the yield of the broader equity market, according to Solberg.

She noted that although REITs come with high dividend yields, they are generally unable to carve out a durable competitive advantage, or economic moat. As a result, 82% of all REIT stocks covered by Morningstar analysts have a moat rating of none.

“You can almost always buy the building or land across the street and build a replica of an existing building to directly compete with any successful business,” Morningstar senior equity analyst Kevin Brown said in the blog post.

“However, we find that these companies add value through proper management, driving operating efficiencies far above industry norms, and through external growth, knowing when to acquire new assets, sell old assets and develop at appropriate times,” he explained.

Brown said Morningstar rates many REITs as having an Exemplary capital allocation rating, a designation for companies with excellent corporate stewardship practices, related to their balance sheet, investments and shareholder distributions.

How Rising Rates and Inflation Affect REITs

High inflation and rising interest rates are creating a mixed picture for REITs right now, Jeffrey Kolitch, who manages the $1.5 billion Baron Real Estate Fund, said in the blog post. “Several REITs offer inflation protection qualities because of their ability to reprice rents often.”

Kolitch cited, for example, hotels, which can set room prices daily, so their ability to offset rising inflation costs can be immediate. Leases for storage center REITs typically renew monthly. “But for interest rates, the answer isn’t simple.”

Rising interest rates affect REITs in two main ways, raising their costs of financing and making dividend yields less compelling relative to fixed-income alternatives, according to Morningstar’s Brown.

“As interest rates rise, U.S. Treasury yield payouts go up, so the risk-free option becomes more attractive relative to REITs,” he said. “Investors shift out of REITs and into Treasuries.”

In addition, he said, “[t]o fund expansions and acquisitions, REITs have to issue new debt. As interest rates rise, funding that growth gets more expensive.”

However, despite the current conditions and investor worries about the economy, a “short-term recession does not change my 10-year outlook on a company at all,” Brown said.

See the gallery for the 10 REITS that are currently trading at the biggest discounts to their Morningstar analyst-assessed fair value estimates.

(Image: Shutterstock)