Real Estate

Don’t write off REITs, especially this unsexy sector

They have been the lump of coal in the Trump rally's equity gift bag: real estate investment trusts.

Investors, however, may be missing out on a good buy, especially in one fast-growing REIT sector: warehouses. These nondescript buildings may be the least sexy sector in real estate, but demand for them is outstripping supply, and rents are rising fast, all thanks to the stunning growth of e-commerce. Still, investors have been leery lately of even this REIT sector, as they shy away from commercial real estate stocks in general.

REIT stocks have lagged other sectors despite solid fundamentals in the commercial properties they represent. Why? It all has to do with interest rates rising.

Xavierarnau | Getty Images

REITs are required to pay out at least 90 percent of their taxable incomes annually in the form of shareholder dividends. That makes them attractive yield plays when interest rates are very low, which they have been for years. Now, with rates rising and the Federal Reserve expected to hike rates on Wednesday, investors have been selling off REITs.

"I think in the last couple of years, there's been this fascination with the Fed and interest rates, and every time there is a rate tantrum, REITs get hit. But they all come back because fundamentally REITs house businesses," said Hamid Moghadam, CEO of Prologis, the largest industrial REIT in the nation. "When business is doing better, which is why yields are going up and everybody's so excited about infrastructure and higher levels of economic activity, well, that aspect of REITs is going to be very attractive. There is going to be higher growth as a result of that."

While e-commerce represents just under 10 percent of Prologis' industrial real estate portfolio, it accounts for about 30 percent of the REIT's new development activity, according to Moghadam. New development includes projects closer in to metropolitan areas, as e-commerce companies now seek to deliver goods to consumers in hours rather than days. Prologis is also developing some of the first multistory warehouses in denser neighborhoods. FedEx Ground and Amazon, shipping smaller packages, are big tenants.

The Sudler Companies is demolishing this 500,000 square foot office building in Cranbury, New Jersey to build new warehouses.
Stephanie Dhue | CNBC

Other industrial REITs, like DCT Industrial Trust, are taking advantage of the growth in e-commerce by shifting their business model. Location, as with all real estate, is everything.

"DCT has positioned itself so that most of their portfolio is located in very large metropolitan areas which is seeing a disproportionate increase in demand from e-commerce and so they're able to track a lot of really interesting, one-off investment opportunities," said Eric Frankel, a REIT analyst with Green Street Advisors, which currently has a buy rating on DCT.

In Cranbury, New Jersey, the Sudler Companies, a privately held developer, is demolishing a 500,000-square-foot office building that used to house an insurance company. After trying to lease it on and off for 10 years and sitting empty for three, the property is being reconstructed into warehouse space.

Forsgate Industrial Partners, a privately held developer and investment company, is rebuilding a 65,000-square-foot office built in the mid-1980s in South Brunswick, New Jersey, to create a 145,000-square-foot warehouse. It is already leased to a high-end retailer. The company is also looking to fill office parks that are empty or have leases expiring in the next three years.

"E-commerce is creating voracious demand for warehouse that's closer to deep-pocketed consumers," said Alex Klatskin, general partner at Forsgate. "There's no demand for suburban office right now, they are dinosaurs roaming the Earth right now."

REITs may also benefit next year from potential tax cuts promised by President-elect Donald Trump. Proposed changes could lower the effective rate for REIT income for top earners from nearly 40 percent to 16.5 percent, according to Edward Mills, an analyst with FBR, who also warns that REITs fare worse with a reduction in corporate tax rates.

"We acknowledge that a reduction in the corporate tax rate, as the Republicans propose, would make the REIT structure less advantageous. Additionally, there is a fear that REITs will become less attractive in a rising-rate environment. However, this ignores that some REIT structures will fare better than others," wrote Mills.

For warehouses in particular, a growing economy and more consumption are key. So, too, is trade, one of Trump's most tempestuous topics.

"I know there's a lot of talk about pressures on trade and the like, but trade is not going away, let's not kid ourselves, and we're part of a very important global economy," said Moghadam. "The rhetoric is exciting. I don't know how the math is all going to work between cutting taxes and infrastructure spending and the like. If the economy can really grow at 2.5 to 3 percent, I think that would be really exciting for our business."

— CNBC producer Stephanie Dhue contributed to this report.

Correction: This story was revised to correct that e-commerce represents just under 10 percent of Prologis' industrial real estate portfolio and about 30 percent of its new development activity.