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What’s right with REITs

Key takeaways

  • Half-empty big city office buildings are a source of risk for their owners and lenders but represent just a sliver of the commercial real estate market.
  • Real estate investment trusts (REITs) can offer investors a unique combination of attractive yields, diversification, and capital appreciation.
  • REITs invest in a wide variety of types of real estate. Among the potential winners are REITs that invest in data centers, assisted living facilities, and manufactured housing.
  • REITs also have unique tax and reporting complexities that other types of investments may not.
  • Careful security selection by experienced managers can help find attractively priced opportunities in volatile markets and manage the risks of investing in REITs.

There’s no shortage of worry about commercial real estate right now. The financial media is filled with anxious talk about big office buildings with more debt on their balance sheets than tenants in their cubicles. According to these sources, the owners of even some of the most prestigious office buildings in central business districts from Boston to San Francisco face the possibility of not being able to make payments on the loans they took out to buy those buildings back before remote work went mainstream.

But while a potential wave of defaults by office building landlords is not out of the question and could pressure the banks that made those loans and the investors who own securities created from them, half-empty office buildings only represent a small slice of the total US commercial real estate market.

Indeed, the gloomy talk about offices obscures the fact that demand is strong for other types of real estate from data centers to warehouses to rental apartments. That strong demand coupled with healthy balance sheets for many of the landlords who own these properties may make investing in real estate investment trusts (REITs) a good way to earn attractive yields while also growing and diversifying your assets.

What are REITs?

REITs are companies that own, operate, or finance income-generating real estate including offices, apartments, shopping centers, hotels, and more. Most REITs are publicly traded and enable investors to earn dividends from real estate without having to buy individual properties. REITs offer the potential for capital appreciation of stocks (and potential exposure to stock market volatility), income in the form of dividends, and also the benefit of exposure to underlying real estate that has tended to gain in value over time.

Furthermore, despite the benefits they potentially offer investors, many REITs may be temporarily mispriced based on pessimism arising from bad news about office buildings. This is creating opportunities for experienced investment managers who specialize in REITs.

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Why invest in REITs?

Steve Buller manages the Fidelity® Real Estate Investment Portfolio (). He says that REITs have benefitted from the higher inflation of the past few years because it has limited the ability of competitors to build new buildings. "The costs for new competitors to enter markets by building new competing properties have gone up tremendously with higher prices for land, materials, and labor. That’s why inflation is a good thing for real estate that’s already been built," says Buller.

Besides its historical role as a source of income, real estate can also provide diversification to partially offset stock market volatility in an investor’s portfolio.

While it's difficult and expensive to get exposure to real estate by buying and managing a building or developing a piece of land, buying shares of REITs that purchase and bundle buildings or land offer a practical and relatively liquid means of doing so. Keep in mind, though, that diversification and asset allocation do not ensure a profit or guarantee against loss.

Potential winners and losers

While REITs overall may be attractive, would-be investors need to understand that not every REIT is equally attractive. REITs typically specialize in certain types of properties such as retail or apartment buildings, and business and consumer trends are transforming real estate markets, benefiting some types of properties and disfavoring others.

Buller says data-center operators have been some of the best performing REITs and he believes they are well-positioned to benefit from long-term market trends. “Data centers are specialized properties through which the world’s online traffic gets routed,” explains Buller. “They were already supported by limited supply and growing demand and the growth of artificial intelligence is making that imbalance even more pronounced.”

He also points out that it’s becoming increasingly difficult to meet the rapidly growing demand for data centers, due to a scarcity of suitable locations to build new ones. “Many customers want to be close to data centers to make faster connections to the internet, but there’s a finite supply of data centers in these ‘ideal’ places,” Buller points out. “Thus, well-located data centers have seen particularly strong growth in rental income and tremendous pricing power in the industry." Data-center rental rates have doubled in the past 12 to 18 months, and customers have been paying the increase because they have little choice if they want to provide fast-enough user connections, according to Buller.

In addition to data centers, Bill Maclay, manager of Fidelity® Real Estate Income Fund (FRIFX), sees 2 potential areas of opportunity in housing: assisted living for seniors and manufactured housing.

Maclay also sees opportunities in bonds issued by REITs, particularly given today's relatively high interest rates. Those high rates mean higher interest payments for investors who hold REIT bonds as well as commercial mortgage backed securities.

Managing the unique risks of REITs

Changes in real estate values or economic conditions can have a positive or negative effect on issuers in the real estate industry. Careful security selection by active managers can help manage the risks of investing in this distinctive and highly variegated asset class. One of the unique characteristics of REIT shares is that they are liquid assets that derive their value partly from the ownership of illiquid assets. That can pose operating challenges because economic downturns and changes in real estate values can have a significant negative effect on real estate owners. REITs also have unique tax and reporting complexities that other types of investments may not.

Experienced managers with deep knowledge of individual companies and real estate markets can help investors avoid some of the risks while potentially gaining the benefits of diversification, income potential, and inflation hedging.

Finding ideas for investing in REITs

Many investors may have some exposure to REITs through diversified mutual funds and ETFs. Those who want to further diversify their portfolios with REITs should determine their existing level of exposure, consider the risks and complexities, and research professionally managed mutual funds and ETFs. You can run screens using the Mutual Fund Evaluator and ETF Screener on

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Changes in real estate values or economic conditions can have a positive or negative effect on issuers in the real estate industry.

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