Investing

Sectors 101: Real Estate

The outlook for real estate is positive as investors watch interest rates and overall stock performance.

by Mark Tosczak - April 09, 2018

Before 1960, if you wanted to invest in commercial real estate, your primary option was to become a landlord — regardless of whether you had the expertise to manage property or the potential headaches that can come with it.

Then in 1960, Congress passed a law creating a new type of investment vehicle: real estate investment trusts, now commonly referred to as REITs (rhymes with “beats”).

“They allow your average investor to own properties they couldn’t possibly own on their own,” says John LaForge, Head of Real Asset Strategy for Wells Fargo Investment Institute.

Since their creation, REITs have grown into one of the primary owners of U.S. commercial real estate. Nareit, an industry trade group, estimates that 80 million Americans own shares in REITs and that REITs own about 290,000 properties in the United States.

Tax advantages and subsectors

REITs are considered tax advantaged investments. Provided that a REIT pays most of its profits out to investors as dividends, it isn’t required to pay corporate income taxes; earnings are taxed at the individual level. This typically means the potential for a higher return on the capital invested.

Most REITs focus on specific subsectors, says LaForge. Some are more consumer focused, like retail property, and some more business focused, such as office buildings or data centers. There are funds that invest in all sorts of assets, including timberland, self-storage facilities, and health care properties.

REITs primarily make money from rents paid by tenants who occupy or utilize these properties. Profits tend to mirror economic activity, both across all kinds of REITs as well as within specific subsectors, LaForge says.

Nareit, an industry trade group, estimates that 80 million Americans own shares in REITs and that REITs own about 290,000 properties in the United States.

Where the value lies

REIT stocks overall right now are relatively inexpensive compared with the underlying value of the real estate they own. Wells Fargo Investment Institute’s 2018 Outlook notes that REITs have been trading at a 4.8% discount to the value of their assets, lower than the 2.5% premium they’ve averaged since 1990.

“We believe the place to stay away from is retail,” LaForge says. “They’ve hit kind of a watershed period.” E-commerce companies have become a serious threat to traditional retail businesses.

A stronger area may be lodging REITs, which own hotels and motels and are “relatively cheap,” LaForge says. “I believe that trend will probably continue.”

REITs in 2018

REIT values dropped in the summer of 2016 as 10-year Treasury note yields started to rise. “It spooked investors,” LaForge says. “REITs have never really recovered that premium.”

If U.S. Treasury yields continue to rise this year, as many expect, investors may move their money into government debt that many consider to be a safer investment, which could push down REIT values.

On the other hand, REITs are often seen as a defensive investment during stock market downturns. Over the last few market downturns, LaForge says, REITs, when measured by the FTSE NAREIT All Equity REITs Index, have outperformed the S&P® 500 index.

In such cases, investors flock to REITs because of their perceived strengths: Their values are based on real assets — real estate — rather than more subjective assets such as the value of a consumer brand, and they pay steady dividends.

LaForge says Wells Fargo Investment Institute is forecasting total returns for REITs in the mid to high single digits for 2018. (Note that total return is the dividend plus the return from an increase in share price.)

Even when stock prices are dropping, companies can still pay dividends to investors, making them more attractive. And REITs usually pay higher dividends. REIT yields average about 4.5% compared with a 2.5% average yield for all stocks.

REITs may also be attractive during inflationary periods, LaForge says.

“They have the potential to be pretty good at being a hedge against inflation,” he says, because property managers can increase rental rates to combat inflation.”

 

There are special risks associated with an investment in real estate, including credit risk, interest rate fluctuations and the impact of varied economic condition.

There are no assurance that forecasts will be met.

Mark Tosczak has spent 25 years wrangling words for newspapers, magazines, businesses, nonprofits, and other organizations. He focuses on health care, science, and business.

Image by iStock

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Wells Fargo Investment Institute, Inc. is a registered investment adviser and wholly-owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.