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REITs Are Poised to Outperform Stocks Next Year. Here Are 3 Picks.

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A housing development in Charlotte, N.C.
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Brace yourselves for an explosive forecast: The U.S. REIT sector could return 10% or so in 2022. Is that stunned silence, or are you nodding off? Either way, stick with me for some analyst picks.

Real estate investment trusts, of course, are companies that own property and can avoid corporate taxes by passing the bulk of their winnings on to shareholders as dividends. As a group, their average long-term returns are…an educated guess. See, REITs were created by Congress in 1960, but the modern REIT era goes back only 30 years to the initial public offering of Kimco Realty (ticker: KIM), and that’s not enough time to judge how an asset class behaves across different cycles.

The National Association of Real Estate Investment Trusts, or Nareit, says REITs tend to outperform corporate bonds, which I buy, because bonds just sit there, whereas commercial properties are managed by people who can respond to changing conditions. It also says that REIT returns rival those of other stocks, which I don’t buy, because if managing rental property were as profitable as everything else, who would bother operating factories? Let’s put average long-term REIT returns a notch below other stock returns, which is still pretty darn good.

This year, however, REITs have provided a total return for the ages. The FTSE Nareit All REITs index has made 34%, versus 26% for the S&P 500 index. That’s one reason the 10% prediction for 2022, which comes from Richard Hill, who runs REIT coverage for Morgan Stanley, looks bold. Doesn’t the group need a breather? Another reason is that the Federal Reserve just signaled an increased willingness to raise interest rates over the coming years. Aren’t rising rates a headwind for income investments?

A third reason is that the house view at Morgan Stanley is that the S&P 500 will end 2022 at 4400, otherwise known as 5% below recent levels. If that pans out, and Hill is proven right on REITs, the sector will have had another remarkable outperformance.

Hill’s forecast rests on the expectation that funds from operations, or FFO, a measure of REIT profitability, will rise 9.4% in 2022 and 7.7% in 2023, excluding a bigger bounceback for hotels. He expects share prices to lag slightly behind FFO growth. Don’t forget dividends—the aforementioned FTSE Nareit index yields just under 3%. “That’s good enough in a relatively ho-hum year to make REITs look really attractive,” Hill says.

For value REITs, Hill likes mall giant Simon Property Group (SPG), which has bought stakes in struggling chains like J.C. Penney and Brooks Brothers. Those aren’t reflected in the valuation, he says, and the dividend was cut during the pandemic, but free cash flow is at pre-Covid levels, suggesting higher payments ahead. Recent yield: 4.4%. Likewise, Kimco owns a $1.2 billion stake in the grocer Albertsons (ACI) that it’s poised to sell in coming years, and which doesn’t appear to be reflected in the stock price. The yield there is 3%.

For growth REITs, there’s AvalonBay Communities (AVB) and Invitation Homes (INVH). If you’ve tried to buy a home recently, you might have been outbid by a half-dozen desperate millennial families, who were in turn pushed aside by Bitcoin tycoons with all-cash offers, who ultimately lost out to, I don’t know, Saudi royalty firing diamonds from cannons.

It’s tough out there. Prices nationwide are up nearly 20% over the past year alone, according to a measure whose name length, fittingly enough, has nearly slipped out of reach thanks to prolonged inflation: the S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index.

That bodes well for rental demand, for now. Hill says Invitation, for example, is increasing rents on new leases by mid- to high-teens percentages, but turns over only about a quarter of its homes a year to new tenants, suggesting years more of fast growth ahead. Invitation, the nation’s largest landlord for single-family houses, yields 1.6%, and AvalonBay, which specializes in apartments, yields 2.6%.

Invitation is the product of a home-buying spree that Blackstone (BX) went on around a decade ago, following the housing crash. It has lately been the subject of some news reports alleging profiteering. A recent article in one major paper, headlined “A $60 Billion Housing Grab by Wall Street,” argued that giant companies are “squeezing renters for revenue and putting the American dream even further out of reach.” The Federal Trade Commission has asked the company for information on how it has conducted business during the pandemic.

Invitation owns a fraction of 1% of single-family rentals, which must make dictating market rents difficult. CEO Dallas Tanner calls some criticism of the company politically motivated, and tells me that he has been raising rents for existing tenants by less than half the pace that house prices have been rising. “You want to show loyalty to your customers, and you start to weigh out the cost of turnover and everything else,” he says.

At the risk of sounding like a capitalist, what if Invitation turns out to not be profiteering enough? Maybe there’s a reason single-family house REITs didn’t exist before the bust, and maybe riding prices back up is as good as it gets. Tanner says that new software and logistics systems have made scaling up single-family rentals more feasible, and that Invitation can gain market share by offering tenants perks that mom-and-pop landlords can’t match, like remote controls for locks and thermostats, and regular replacement of air filters.

One last note for house shoppers: Tanner attributes the recent price run-up to millennials forming households, homeowners staying put during the pandemic, builders still feeling risk-averse from the last housing bust, and delays in securing critical construction items like doors. Price growth should revert to 5% to 7% a year, he says, but that could take another six months.

Write to Jack Hough at jack.hough@barrons.com. Follow him on Twitter and subscribe to his Barron’s Streetwise podcast.

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