Editor’s Note: Last time, we spoke with Brad about the bumpy road for commercial real estate. Today, we’ll ask him his favorite investment opportunities in this market, and the surprising evolution of some REITs.

Van Bryan (VB): Brad, evaluating real estate investment trusts (“REITs”) is one of your specialties. I’d like to ask you about the REITs you’re watching right now. But for newer readers, could you bring them up to speed on what these assets are?

Brad Thomas (BT): Sure thing. A real estate investment trust – or REIT – is a company that owns, operates, or sometimes finances real estate assets. In most cases, by owning a REIT, an investor becomes a part owner of a real estate portfolio, whatever it may be. As a former developer, I understand these assets very well, and I’ve been a big proponent of them for years. And that’s for a few reasons.

First, the best-managed REITs tend to be very generous, very reliable dividend payers. That’s partly because of their corporate structure, which requires them to pay out at least 90% of taxable income to investors.

We can look at a company like Realty Income (O) as an example. The company owns more than 15,000 properties. And these properties are everything from convenience stores to grocery stores, fitness centers, restaurants, it even has an interest in a few casinos.

From an investment perspective, Realty Income yields close to 5%. You can compare that to the S&P 500 Index, which is below 2%. But more important is how reliable Realty Income is. The company has paid 654 consecutive monthly dividends.

And the company has raised that dividend for 109 consecutive quarters. That’s why I think it’s a mistake to compare a quality REIT like this to bonds, which a lot of people do. For a bond, the coupon is pre-determined. It doesn’t change. But a great REIT can grow earnings, increase dividends, and let investors take advantage of compounding.

The company is able to do this because – unlike many C-corporations – its earnings tend to be very predictable. That’s because the company has what we call “rent escalators” built into the leases with its tenants, which simply means they’ll pay more in rent over time. And that allows you to forecast revenue and earnings with a lot of specificity. This is one of the reasons, in the spirit of full disclosure, I’ve owned shares for years.

Another big benefit of quality REITs is that they provide instant diversification. How many of us will ever be able to own physical infrastructure like cell towers? Or hundreds of acres of timberland? Or an apartment building? Probably not many. But there are REITs that allow you to do just that. It’s a great way to add diversification to any portfolio.

So, I’d say that’s sort of the elevator pitch for quality REITs: diversification, reliable income, rising dividends.

VB: And what areas of the REIT market are you interested in right now?

BT: Sure, let’s talk about a few…

Health care is a really interesting sector right now. Of course, you have all the different sub-sectors here. You have nursing facilities, which is being driven higher by an aging population and the “silver tsunami.” And then you’d have something like hospitals, which are “mission critical.” And then you have something like life sciences buildings, which I think are going to continue to benefit.

Just on that last point, one REIT we like is Alexandria Real Estate (ARE). It’s technically classified as an office REIT, but it’s really not. The company owns laboratory research facilities. Its clients are some of the largest names in the health care industry. But because people think of it as an office REIT, it’s been really unloved since the lockdowns.

Never mind that it’s collected nearly 100% of its rents over the last five years. And never mind that it’s posted positive adjusted funds from operations – a good proxy for cashflow – for eight of the last 10 years. And yet the stock is well below its historical valuation. So, that might be one interesting place to look.

Apartment buildings? Very solid. It’s a simple argument. People have to live somewhere. And homes are still unaffordable for many. So, apartments are what they go with. A REIT we’ve held for a long time is Mid-America Apartment Communities (MAA). And they’re heavily focused on the Sun Belt, which I think is the place to be.

An area I really like is net lease. These are companies like Realty Income. The structure of their leases means that all the costs of owning the properties – taxes, insurance, maintenance, etc. – are the responsibility of the tenant. That’s great news if you’re a landlord.

But I’m really bullish on this space. They still have more favorable cost of capital compared to their peers. And they’re able to assemble very large portfolios as a result.

I was actually talking to the Chief Financial Officer of Realty Income recently. And one interesting thing he said was that the company is entering the private capital business.

VB: What does that mean, exactly?

BT: In essence, they’d be competing with companies like Blackstone and some of the other private equity funds and private credit real estate owners. And when I look at the net lease sector, more and more I’m comparing it to the banks. That’s because a lot of these businesses are really more like banks disguised as REITs. That’s because they finance just about everything.

So, Realty Income could buy a theme park and lease it back. It could buy an NFL football stadium and lease it back. It’s just a form of financing. And it’s something a lot of people don’t understand.

This private-equity-type business is really interesting. And it’s a great way to scale the business. They’ve invested in data centers, farming, casinos. You name it.

One other thing I expect to happen in this space is a wave of consolidation. Mergers and acquisitions has really stalled out over the past few years, and I think that changes under Trump. Perhaps we can talk about that a little later. But a company like Realty Income has such incredible cashflow and such advantageous cost of capital, I wouldn’t at all be surprised if we see a wave of acquisitions.

People really don’t know how fragmented this market is. And it wouldn’t take much to see several mergers, similar to what happened with the banks in the 1990s.

VB: What about areas of this market you’re concerned about?

BT: Industrial and logistics is going to be interesting. Because there’s certainly some risk there with tariffs. So, we’re on the lookout for any major disruptions with warehousing or logistics facilities. I don’t think that will happen, but it’s worth watching.

And then there’s offices…

You’d be hard pressed to find a more troubled area of the real estate market in the last few years. With the lockdowns, you just didn’t have the demand you once did. And even though we’re four years on, so many of these properties have continued to struggle.

That said, it’s not all bad. For something like offices, geography is important. And, like I just mentioned, I really think the Sun Belt is the place to be. These states are seeing a lot of migration, and it’s attracting a lot of business. But then you have areas that people are leaving like New York and San Francisco. And I just don’t see how that works out well for office landlords.

Sure, there’s attempts to convert office buildings to residential housing. But that’s extremely capital intensive, and very risky. So, for an individual investor, I might be underweight office buildings.

A bit of a wildcard will be government buildings. These are companies that lease buildings to what I call the “gun-toting agencies.” So, that would be the DEA, the FBI, the IRS, etc. One REIT in this space is Easterly Government Properties (DEA).

And if there is a big push to downsize the number of government employees under a Trump administration, you really have to wonder what will happen to these buildings. So, I’d be a little cautious there.

Moving over the lodging, we’re keeping an eye out for any impact a recession might have, assuming we get one. That’s because hotels are so closely tied to business travel. And so, whenever you have a recession, you tend to see hotels get hurt.

But at the same time, you have different categories of lodging. You’ve got the luxury component and then the businesses with more limited service. That’s more like a Hampton Inn. And if there is a recession, I might take a closer look at a Hampton-Inn-type product.

Because, if business is cutting back, they’ll prefer to use a Hampton Inn before they book at the Four Seasons. But overall, lodging just hasn’t performed well, and so I might be underweight here as well if I was building a REIT portfolio.

VB: If you had to make a forecast for overall REIT performance in 2025, what would you say?

BT: Well, again, it can be difficult to forecast for this larger market. Because, as we just discussed, there are so many sectors and sub-sectors.

I wouldn’t at all be surprised to see some areas struggle – think office REITs in big cities. Meanwhile, you have tremendous performance from data centers or from the net-lease space.

But overall, I’d say a lot of the headwinds for REITs have the potential to become tailwinds. If interest rates continue to fall, all else equal, it makes the yield from bonds less attractive. And all of these generous-paying REITs, which have really been overlooked, finally get some attention. The dividends are great, but I’m looking forward to some meaningful capital gains.

Just looking at Realty Income again, the stock is basically flat over the past 12 months. After an entire year, the share price really hasn’t moved.

But at the same time, Realty Income has increased its funds from operations. It has increased its dividend. And it’s expanding into these really interesting markets. By almost any metric, it’s a better company than it was 12 months ago. But it’s just not being reflected in the share price.

It can be frustrating, but it’s okay. Because it means companies like this – and so many other great REITs – are almost criminally undervalued in my opinion. But that can work for investors looking to build out this segment of their portfolio.

Sooner or later, Mr. Market will take a second look at these companies and realize what great businesses they are. It might take some time, but I’m confident it will happen.

VB: Thanks, Brad.

BT: Anytime.

MAILBAG

Have you been following Brad through his REIT advice? What is your take on the REIT world of investments? Write us at [email protected].