Niche Investing in REITs can Pay Off Handsomely

Many real estate investment trusts (REITs) offer good long-term potential returns, despite relatively poor performance in third-quarter and early fourth-quarter 2016.

The key for fans of income investments to find investment-worthy REITs right now is to focus on selected niches. Although REITs are interest-rate-sensitive in the short term, they generally follow the strength of the overall economy.

Now trading at roughly a 5% discount to net asset value, compared to the usual 2-3% premium, the expected hike in interest rates may provide discerning investors with a buying opportunity.

As of Oct. 31, REITs were paying an average dividend of 3.94%, compared to a 1.8% return from U.S. Treasuries and 2.7% from the S&P Investment Grade Corporate Bond Index. In an era where the European Union and Japan have negative interest rates, the lack of investment alternatives for income investors should help to support the current prices of REITs.

Indeed, money has been pouring into the sector. Nearly $85 billion was pumped into the U.S. commercial property market and roughly $104 billion went into the residential market by foreign investors alone in 2015, according to the National Association of Realtors. Much of the money came from Asia, the Middle East and Europe. Forecasts offer no indication of a slowdown in fund flows in 2017, with the generally weak economic outlook in those parts of the world.

In addition, rising interest rates in the short-term do not necessarily spell doom for the sector. The turmoil in the bond market in 2016, coupled with a hot real estate market, have pushed the spread between the cost of borrowing and the return on investment to roughly 3.25%, more than a percent higher than in 2015. These wider-than-usual spreads between property yields and interest rates should provide a cushion to the sector for a while.

So, with the recent tumult in REIT prices, increasing market volatility in 2017 and a rising interest rate environment, what bargains remain? Let’s consider warehouses and office space.

When unemployment falls, commercial/industrial REITs that specialize in office space tend to do well. As the economy improves, businesses expand and are able to hire more people, as well as invest in in office space. In fact, average office vacancy rates are now below 17% – the lowest they’ve been since 2009, according to REIT.com.

The industrial sector is also poised to outperform in 2017. As e-commerce booms while disrupting the retail industry, demand for warehouse space also increases simultaneously. Nearly 60 million sq ft of warehouse space was built in the last 12 months in the US alone. Across the US, there is less than 7.5% vacancy rate in the large warehousing sector according to a 2015 report by real estate firm Colliers International. Demand is also growing rapidly for distribution centers, specialized technology & life science spaces as the health of the economy continues to improve.

For those who are undecided on how to play the commercial/ industrial REIT space, check out Liberty Property Trust (NYSE: LPT). This hybrid warehouse & office space REIT is currently trading around $40, while yielding a handsome 4.9%. LPT also is up about 25% year-to-date.

Liberty is one of the nation’s leaders in developing high-performance green buildings. The $9.5B REIT has more than 728 industrial/ warehouse and office properties and approximately 1,700 tenants, including Amazon, Proctor & Gamble, Vanguard and GlaxoSmithKline, among hundreds of others.

LPT has been re-positioning itself for the next few years by shedding non-core office properties in suburban markets to focus on its core office properties in the major cities along the East and West Coasts, the Midwest and London. The company is also focusing more on the industrial sector, with approximately 90% of their assets invested in warehouses and distribution centers. A vacancy rate of roughly 6%, coupled with a solid balance sheet and increasing demand for well-located, good quality industrial spaces, should help this REIT do well as the economy continues to grow in 2017.

Data Centers & Technology

Technology has been one of the best-performing market sectors for the last couple of decades and there are ways to profit in this trend through specific REITs. Data center REITs own and manage buildings and warehouses that are specially equipped to store massive amounts of data.

Data centers provide core IT functions like networking, communications, processing and storage to pretty much any company that manages data. Because of the costs and complications associated with data storage (such as expensive technology, power, security and maintenance requirements), expect many companies to continue to outsource their data needs to these specialized third parties. Additionally, market demand seems to be ever increasing from companies that operate in the digital entertainment, cloud computing, artificial intelligence and data analytics spaces.

For those interested in this technology/real estate play, consider the Digital Realty Trust (DLR). This approximately $15B REIT manages 156 data centers across 11 countries. Over the last decade, DLR has tripled the S&P’s returns.

Despite being down roughly 13% in the last 3 months, DLR’s stock is up approximately 22% for the year. Yielding an attractive 4% and trading these days at a much more reasonable 15 times earnings, DLR also has an excellent record of raising its dividend for the last 11 years.

Servicing companies from a well-diversified array of economic sectors, including financial services, cloud & IT services, manufacturing, energy, health care and consumer products, this company is poised to weather any interest rate storms & flourish over the next few years as the market for data storage grows in conjunction with buzzword industries like “Internet of Things,”, “Cloud computing,” “Big data,” “Video streaming” and “Artificial Intelligence.”

Karn Brij is a managing director at an international investment firm with interests in real estate, banking and alternative investments. He specializes in real estate, finance and India-focused investments.