Were you forwarded this email? Subscribe here for free.

Why You Should Be Buying REITs

Technology stocks have been crashing the markets, and AI will change the world. REITs have been boring. Office properties have been deadly. Why not just buy the S&P 500 and forget about it like the experts suggest? That has been working very well for the past decade.

I am not opposed to buying an index fund and keeping it forever. The trick, however, is to steal a page from Warren Buffett's book and buy the index fund in a nasty stock market.

We are not in a nasty market.

Whatever your long-term approach, REITs should be a part of it. Since Sam Zell and a few others transformed real estate investing by creating the modern version of real estate investment trusts, equity REITs (those that own property and are not mortgage lenders) have crushed the S&P 500 by a fairly wide margin, according to the data on REIT.com:

Since January of 1972, equity REITs have averaged 11.18% versus the S&P 500’s 7.88%. I will also note that about half of the S&P 500's return comes from dividends, and the current payout on the index is a paltry 1.4%.

As we will discuss at length in future issues, focusing on the Big Five approach to real estate investing should allow you to capture most of the benefits of real estate and REIT returns. Of course, those who want to maximize those returns and enhance the income they receive from their portfolio should check out the premium version of the Melvin Real Income Report (coming next week – upgrade now to get access as soon as I release it).

Now, onto this week's market updates and conditions:

Where We Are Today

2024 US Economy and Commercial Real Estate Overview

As we move through 2024, the US economy and commercial real estate (CRE) markets continue to navigate a complex landscape shaped by economic uncertainties, shifting work patterns, and evolving consumer behaviors. Today we’re going to examine the current state of various CRE sectors, including multifamily, office, retail, and industrial properties, while considering the broader economic context and future outlook.

Economic Context

A delicate balance between growth and potential recession risks characterizes the US economy in 2024. The Federal Reserve's monetary policy decisions continue to play a crucial role in shaping economic conditions. Federal Reserve Bank of Kansas City President Jeffrey Schmid has signaled caution regarding interest rate reductions, citing inflation concerns and a still-healthy labor market. This stance suggests that while the economy has shown resilience, policymakers remain vigilant about inflationary pressures.

Recent economic data has raised questions about the sustainability of the "soft landing" scenario. July 2024 saw a modest job growth of 114,000, significantly below the previous 12-month average of 200,000. The unemployment rate edged up to 4.3% from 4.1% in June, prompting discussions about the lagged impact of monetary policy tightening that began in March 2022.

Despite these concerns, several economic indicators remain positive. Air travel, restaurant visits, retail sales, and hotel occupancy rates continue to show strength, suggesting that consumer spending remains robust in certain sectors. The second quarter of 2024 saw a GDP growth of 2.8%, indicating underlying economic resilience.

Commercial Real Estate Market Overview

The commercial real estate market in 2024 presents a mixed picture, with varying performances across different sectors. Overall, the market is adapting to new realities brought about by changes in work patterns, consumer behaviors, and economic conditions.

Multifamily Housing Market

The multifamily housing market remains a dynamic and crucial component of the CRE landscape in 2024. Many markets tracked by CBRE are expected to grow their inventories significantly in 2024 and 2025. Construction completions have peaked in several markets, including Chicago, Washington, D.C., and Las Vegas, with most other markets expected to peak in 2024.

Average rent growth is projected at a modest 1.2% in 2024, down from previous years due to supply headwinds. Despite economic uncertainties, the average occupancy rate is expected to remain above 94%.

Rent growth and occupancy are strongest in the Midwest and Northeast regions, as well as mature urban hubs like New York, Boston, Chicago, and Washington, D.C. Sun Belt and Mountain regions are experiencing some negative rent growth but are expected to attract in-migration due to relatively lower rents.

Softer fundamentals and higher borrowing costs have created buying opportunities for investors, especially those with a long-term perspective. The Midwest and Northeast regions offer the best opportunity for positive leverage in 2024, with cap rates typically higher than elsewhere.

Several markets stand out in the multifamily sector:

• San Diego benefits from limited supply growth and strong demand from life sciences jobs.

• Boston's growing tech and life sciences sectors, coupled with a limited construction pipeline, bolster market fundamentals.

• New York City continues its post-pandemic resurgence, with one of the lowest overall vacancy rates in the country.

• Dallas remains the largest and most liquid market for multifamily investment, despite supply pressures on rent growth.

Office Sector

The office sector continues to face significant challenges in 2024, primarily due to the ongoing shift in work patterns and the slow return-to-office trend. Office occupancy stood at 49.7% for the week ending September 27, 2024, according to Kastle Systems' 10-city Back to Work Barometer. Leasing activity across the United States remains well below 2018 levels, creating challenges for raising net effective rents and growing occupancy.

National office vacancies reached a high of 20.6% at mid-year, according to JLL. Negative absorption over the past three years has contributed to rising vacancy rates. However, major employers like BlackRock, Goldman Sachs, Amazon, and Salesforce are implementing new return-to-work mandates, requiring employees to be in the office for at least three days a week.

A flight to quality is evident in the office market, with Class A buildings accounting for a significant portion of all office leasing. Top-tier office buildings have vacancy rates notably lower than the rest of the office market.

Office REITs are focused on maintaining and upgrading high-quality assets in prime locations. Investments in amenities and creating collaborative environments are key strategies to attract tenants. REITs have had access to capital that private developers and owners have not during the post-COVID dislocation, and that has created a significant advantage for REIT-owned Class A office properties.

Retail Sector

The retail sector in 2024 shows signs of resilience and adaptation to changing consumer behaviors. The national retail vacancy rate held steady at 4.1% throughout the first half of 2024, but demand for retail space surged significantly over the past year.

Leasing activity is predominantly concentrated in smaller spaces under 2,500 square feet, driven by quick-service restaurants and personal services. The food and beverage sector accounts for a substantial portion of all leasing activity.

Construction activity in the retail sector remains active, with a focus on build-to-suits, grocery-anchored centers, and smaller retail formats within mixed-use projects. Overall, average retail asking rents have seen modest increases, with mall rents and shopping center rents showing slight growth.

In-person shopping shows signs of recovery, with visits to indoor malls and open-air shopping centers up compared to the previous year.

Industrial Sector

The industrial sector continues to be a strong performer in the CRE market. E-commerce growth and logistics needs continue to drive strong demand for warehouse and distribution space. The sector benefits from robust investment activity due to its stability and growth potential.

Vacancy rates remain low in the industrial sector, highlighting the high demand and limited supply of industrial spaces. Rental rates have seen significant growth compared to other CRE sectors.

Where We're Heading Next

As we look towards the latter half of 2024 and beyond, several factors will shape the US economy and CRE markets. The path of inflation and Federal Reserve policy will be crucial in determining economic growth and interest rates. Labor market dynamics and consumer spending patterns will influence demand across various CRE sectors.

The multifamily sector is expected to play a crucial role in addressing housing shortages, with a potential for strong recovery in occupancy and rent growth by 2026. The office sector's recovery may be a longer process, possibly extending several years, with a likely reduction in overall market size.

The retail sector is expected to continue its adaptation to changing consumer behaviors, with a focus on experiential offerings and mixed-use developments. Strong performance will likely continue in the industrial sector, driven by e-commerce and supply chain optimization needs.

During the pandemic and its aftermath, industrial and warehouse space was the hottest sector in the REIT markets. The combination of demand from the explosion in e-commerce and the need to completely remake the nation's supply chain quickly gobbled up almost all available space.

Starved for projects by the turmoil in office and retail, everyone with a hammer and a contact at the zoning agencies turned to the industrial market and began building space. That space quickly filled up as the demand was urgent and fast-growing.

Now, available space is being absorbed quickly, and there is very little new construction in the sector. Demand for space is still growing as e-commerce takes market share, and local warehouse demand is still very strong.

Space is going to be hard to find in 2025 and 2026. Permitting and financing for new projects take some time, and right now, there is not much new construction on the drawing board across most of the United States.

What You Can Do About It

While the US economy and CRE markets face challenges in 2024, they also present opportunities for adaptive and forward-thinking investors.

The advantages that REITs have over private real estate funds are becoming more obvious with each passing day. Having access to capital market funding is a massive advantage.

So is owning the best properties in a given market. The portfolio of real estate investment trusts often means that they are the best in class in almost every important market and sector of the real estate landscape.

Speaking of, if you haven’t yet, check out my recent special report on The Big Five REITs – And Why You Should Own Them.

And stay tuned for next week. In addition to the next free issue, I’ll also be releasing my first monthly premium issue, including my full list of REITs that are in excellent financial condition, with outstanding fundamentals and a high-quality portfolio. This model REIT portfolio is diversified across segments of the real estate market, and aims for above-market total returns.

In short, it’s a list of the best REITs to own right now.

Thing is, this monthly portfolio issue is only for Premium members. So upgrade now to get access as soon as I release it!

Tim Melvin
Editor, Melvin Real Income Report