Office space stands out as the drag on REIT performance, while cell towers and data centers ride the technology wave
Financial advisors looking for a steady and stable income allocation inside client portfolios often turn to real estate investment trusts. But, like any investment category, real estate is not one-size-fits-all, and the distinctions can be stark among REIT products.
“We view real estate as an asset class which will frequently have an allocation in most client portfolios,” says Ben Sayer, alternative investments group head and managing director at MAI Capital Management.
However, the challenge is navigating the pockets of opportunity. “Right now, we see value in certain sectors of real estate, but other areas are priced to perfection, requiring high levels of future rent growth, which may or may not come through, to drive returns,” Sayer says.
“When reviewing any real estate opportunity, whether in a public REIT, private REIT, or in a private fund, we always want to understand the sources of potential return, including acquisition cap rate, future rent growth assumptions, underlying lease structures, expense expectations, and exit cap rate assumptions.”
As an investment category that relies heavily on debt financing, real estate returns are directly impacted by the direction of interest rates, which are now more favorable than just a few years ago.
“The opportunity in the space, given the back-up in rates we’ve seen the last few years, is that the worst of the upward movement in rates is behind us, and REITs offer an attractive stream of income going forward, with minimal capital erosion from further increases in interest rates,” says Steve Kolano, chief investment officer at Integrated Partners.
“The risk to that opportunity is with potential tariff implementation there may be a leg higher in rates if the impact of tariffs flows through the underlying inflation.”
In terms of the best ways to invest in real estate, Craig Robson, founder and managing director at Regent Peak Wealth Advisors, recommends a diversified allocation to both publicly traded and private REITs.
“Owning real estate within a comprehensive portfolio construct is overall beneficial, but knowing what type of real estate one owns and where they own it is super important,” he says.
Publicly traded REITs are typically packaged as mutual funds or exchange-traded funds and are suited to investors of all levels of net worth. Public REITs trade on exchanges with full liquidity, varying levels of transparency, and live or daily valuations.
Phil Bak, chief executive of Armada ETF Advisors, manages the Residential REIT ETF (HAUS) and describes himself as “extremely bullish on the sector.”
From Bak’s perspective, public and private REITs often play off each other, and the less liquid private versions can sometimes create performance separations.
“The public market REIT space has been beaten up, but when you talk about real estate assets, the variations are favorable thanks to a residential supply-demand imbalance,” he says. “Comparing public REITs to private real estate, the valuations are significantly more favorable for public REITs, and our thesis is that those valuations will converge.”
Evan Serton, senior portfolio specialist on the REIT team at Cohen & Steers, also sees brighter skies on the horizon for real estate investing.
“We’re in the midst of a recovery for real estate,” he says, citing the pain of just a few years ago when a series of economic forces, including higher inflation and rising interest rates, were moving against the category.
Cohen & Steers, which manages more than $85 billion firmwide, runs nine REIT mutual funds and one REIT ETF. Its real estate flagship, the Cohen & Steers Realty mutual fund (CSRSX) is up 4.2% from the start of the year, which compares to a 1.7% decline for the S&P 500 Index over the same period.
“When you look at public REIT valuations versus the S&P, they are trading at discounts to stocks that are sizable relative to history,” Serton says.
The stickier inflation that puts a drag on other areas of the economy is an advantage for real estate investors, he says, “because landlords don’t have a lot of sensitivity to labor costs and commodity prices, but inflation raises the cost of bringing new real estate to market.”
“We’ve long talked about real estate being an effective hedge against rising prices,” Serton adds.
One caveat, however, is the risk of stagflation when a slow-growth economy is saddled with high unemployment and rising prices. “Stagflation is very challenging for listed real estate performance,” Serton says.
On the private REIT side, the risks and opportunities are generally the same, but the reduced levels of liquidity, portfolio transparency, and daily valuations can create a different psychological impact on investors.
“I think there’s always an advantage for the private wealth investor because the general lack of volatility can benefit a typical investor portfolio,” says Brent Jenkins, managing director and portfolio manager at Clarion Partners, which manages $73 billion worth of private REIT funds.
Clarion, which is majority owned by Franklin Templeton, expanded into the private wealth space about 10 years ago to offer access to wealthy individual investors.
The reduced volatility of private REIT funds Jenkins refers to is simply the result of not being able to track daily the valuations of underlying portfolio holdings, which is the purest way to invest in long-term assets like real estate.
Beyond the reduced liquidity and other private REIT factors, including higher investment minimums, Jenkins sees a roadmap for real estate that is similar to what the public fund managers are seeing.
“We’re at the beginnings of a new cycle for real estate,” he says. “Higher rates led to repricing, generally, but as of the beginning of 2024 liquidity started to return to debt markets and that led to the beginnings of a new cycle of healthy supply and demand fundamentals.”
As far as specific real estate sectors go, the consensus is that office space remains an outlier that is still trying to recover from rising vacancy rates during the COVID pandemic.
Stephen Tuckwood, director of investments at Modern Wealth Management, is going slightly against the tide, seeing an opportunity to get in early on commercial real estate.
“There are signs of life appearing in the commercial real estate market, indicating the potential of the market finally beginning to bottom out, although there is likely still more room to go in the deeply troubled sectors, such as office space,” he says. “In our view, a prudent entry or re-entry into commercial real estate right now is via newer vintage debt strategies.”
Sayer of MAI Capital Management sees a “bifurcation of opportunities” in the REIT space. “There are those where capital needs are so large that it’s driving an interesting risk-return proposition, and others, which are more contrarian, where the supply of capital has really pulled back,” he says.
“An example of the first would be data centers, but we’re seeing a difference in expected returns between developing new data centers and publicly traded REITs that focus on data centers,” Sayer says. “An example of the second would be office. While we don’t believe office is out of the woods just yet, we have seen some market thawing there with a few transactions, and we have seen some interesting transactions with single-tenant headquarters where the tenant is of high credit quality.”
Data centers and cell towers stand out as strong performance subcategories within real estate, but some fund managers warn against chasing performance of REIT funds relying too heavily on those areas.
“Data centers and cell towers have correlations to technology, especially following the AI craze that has pumped up those valuations,” says Bak of Armada ETF Advisors.
Serton of Cohen & Steers agrees that funds loaded with the technology proxies could be souping up performance.
“The property types that predominate in the listed market are cell tower and data center REITs that are both fueled by technology performance,” he says.