An overlooked yield opportunity

If you've read anything about REITs in the press in recent months, it was probably negative headlines about empty downtown offices and a steady parade of landlords turning the keys over to lenders.

But dig a little deeper into the commercial real estate universe and there is a wealth of potential opportunity for investors to discover. In fact, commercial real estate is far broader than simply urban office towers. Most REIT sectors are healthy and flourishing. And the asset class can offer growth, relatively high income, and potential diversification benefits. Fidelity fund managers have uncovered attractive real estate opportunities among both stock and debt investments.

A unique asset class

First, let's define REITs. These are companies that own, operate, or finance properties across a diverse mix of sectors including offices and cell towers, apartment buildings, warehouses, retail and data centers, health care, and self-storage facilities. Listed on stock exchanges, REITs provide an easy way to access (with full liquidity) commercial real estate that would otherwise be out of reach for individual investors.

To qualify as a REIT, these businesses must distribute at least 90% of their taxable income each year. This then unlocks special tax advantages for REITs, which can deduct all of the dividends they pay out from their corporate taxable income (most REITs pay out at least 100% of taxable income to shareholders, and therefore owe no corporate income tax).¹ This advantage effectively allows REITs to avoid the "double taxation" that most companies face—in which the corporation pays taxes on its profits, and then investors also pay taxes on profits.

Due to that 90% distribution rule, REITs tend to offer relatively high yields in comparison to broad stock investments.² A kind of hybrid between stocks and fixed income, real estate moves considerably out of synch with the 2 traditional asset classes, and thus can provide potential diversification benefits for a multi-asset portfolio.

It's important to understand that illiquidity is an inherent risk associated with investing in real estate and REITs. There is no guarantee the issuer of a REIT will maintain the secondary market for its shares and redemptions may be at a price which is more or less than the original price paid. Changes in real estate values or economic downturns can have a significant negative effect on issuers in the real estate industry.

More than just office space

Steve Buller has managed Fidelity^® Real Estate Investment Portfolio () since 1998. During that quarter of a century, he witnessed both enormous growth in the industry (in the number of listed REITs and market value) and dramatic change in the composition of the sector.

"The REIT market used to be dominated by traditional office, retail, and apartments," Buller says. "But over time the listed market moved to health care, data centers, cell towers, timber, and self-storage," he says.

While the office sector accounted for nearly 20% of REIT assets in 2010, by 2023 it had shrunk to just a 3% share—overtaken by faster-growing sectors including infrastructure and industrial properties.³

A potential inflation hedge

The current market environment of high inflation and interest rates brings both challenges and opportunities for REITs. Typically highly leveraged and capital-intensive businesses, real estate is vulnerable to rising rates (and higher capital costs). Rising rates also lead to higher yields on bonds, which some investors perceive as yield competition for REITs.

On the other hand, as "real assets" (i.e., tangible physical assets), property can provide more inflation protection than many investments. "Many leases have inflation adjustments," says Buller. "And properties with shorter leases, like hotels and apartments, are able to reprice more quickly," raising rents to stay ahead of inflation.

In addition, he notes, high inflation in construction costs (like for labor and materials) has been constraining new building and pushing up rents in multi-family housing and other supply-constrained sectors.

Opportunities in data centers, senior housing, and more

Within the REITs universe, a number of sectors have shown promising long-term growth potential.

Data centers—where cloud providers turn to meet their massive storage needs—are one such sector. Buller says that the rise of artificial intelligence is accelerating the demand for these interconnection sites, which benefit from restricted supply and strong pricing power. Equinix (), a dominant data center operator around the world, is a digital infrastructure provider that has illustrated this theme.

Another theme that could have legs is health care real estate. Bill Maclay, manager of Fidelity^® Real Estate Income Fund (), sees particular potential opportunity for senior housing, which enjoys a "huge demographic tailwind," he says. A rapidly aging population in the US and some other developed nations should support demand for quality assisted living and memory-care facilities. These facilities generally cater to older individuals who can afford to pay rent out-of-pocket for their rooms.

Welltower () and Ventas () are senior-housing REITs that have exemplified this trend. Both operate facilities in Canada and the UK, along with the US, and both are also invested in other health care properties such as outpatient rehab centers, medical offices, and life-science research spaces.

The nationwide shortage of affordable housing has created opportunity in the lower cost manufactured housing market, says Maclay. This sector includes RV resorts and mobile-home communities, including ones aimed at retirees. He particularly likes the economics of these business models, since the owner/operator simply owns the land under the homes, collects rent, and doesn't need to invest much.

"Limited need for capital expenditures translates into good free-cash-flow generation," says Maclay. One prime beneficiary of the strong structural demand for manufactured housing has been Equity LifeStyle Properties (), which owns and operates hundreds of residential communities, resorts, marinas, and campgrounds across the country.

A good time to be a lender

A different approach to real estate is to invest in debt as well as in equity, which is the approach of Maclay's Real Estate Income Portfolio (this strategy may offer lower volatility and higher income than a purely equity-REIT portfolio). "I invest across the whole capital structure," he says. This can include real estate preferred stocks, corporate bonds, and commercial mortgage-backed securities (CMBS), along with equity REITs. This flexibility has been particularly valuable in the current market, since high interest rates translate into high income and yields for fixed income assets.

"It's good to be a lender today," Maclay says. "You don't need to take a lot of credit risk for yield, since short-term and Treasury rates are high and bond credit spreads are wider than historic averages."

As with evaluating traditional stock REITs, when evaluating debt opportunities Maclay looks for underlying properties that can benefit from long-term growth drivers and growing rental income. "CMBS credit spreads are very wide, so the fund can own high-quality investment-grade bonds with very attractive yields, which creates a setup for a potential total return opportunity," he says.

To mitigate interest-rate risk, Maclay tends to own floating-rate securities in which interest rates can reset higher in line with rising market rates, a structure that reduces interest-rate sensitivity. This even applies to preferred real estate securities, where he focuses on an unusual flavor of preferred stock with the ability to flip from a fixed to a floating rate after a set period—adjusting, say, from a 6% to 10% coupon.

Steering clear of office space

Offices may account for a relatively small portion of REIT indexes—at least compared to their weight in the headlines—but still, "not owning offices is a big theme," says Buller. The move toward hybrid and remote work continues to hurt demand for office spaces in big cities like New York and San Francisco. And office occupancy rates could continue to decline as leases expire and come up for renewal.

Still, savvy investors should remember that those "for lease" signs scattered around major cities are telling a comparatively small portion of the current story of real estate. Indeed, the outlook for many segments of the real estate investing universe looks bright.