Why Morgan Stanley Sees "Pockets Of Opportunity" In REITs. Here Are Some Sectors To Consider

Although every modern business sector depends on credit, few are as sensitive to increased borrowing costs as real estate. That's why the Federal Reserve's several yearslong policy of raising interest has complicated market conditions across the REIT sector. With that said, there is always potential upside in challenged markets, and Morgan Stanley's Ron Kamdem sat down with CNBC to discuss the "pockets of opportunity" he sees in the REIT sector.

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Why Are REITs So Affected By Interest Rates? 

High interest rates translate to diminished buying power for every buyer who finances a real estate transaction. When the borrower is a real estate investment trust (REIT), there is even more pain to spread around. Higher interest rates eat into investor profits by making it more expensive for the REIT to purchase new property or refinance an existing loan on portfolio assets. 

This is the source of the angst regarding the commercial real estate sector. Even after accounting for the Federal Reserve's highly anticipated rate cut, many office and commercial REITs will refinance their loans at significantly higher rates than the REIT fund managers anticipated when they took out the original loans. Pair that with drastically reduced office demand and you get a recipe for a troubled REIT sector. 

Other REIT sectors are also facing some difficulties due to the higher financing costs, but the space in their sector is in much higher demand than office space. That makes higher interest rates more of an unexpected obstacle to account for than a potential deal killer. 

Ron Kamdem's Outlook 

Ron Kamdem leads the REITs and commercial real estate team for Morgan Stanley. He discussed the effect of higher interest rates by saying, "This year, interest rates have been higher than anticipated. If you think about the beginning of the year, everybody thought the Fed would be cutting in March, now those expectations have been pushed back to September if not later, and that's been a headwind for the REIT market." 

Although Kamdem admitted the REIT sector may be in a downturn, he stressed that he doesn't think it's permanent. He added, "I want to remind want to remind everyone that there has been lots of diversification in the REIT market, and there are pockets of opportunities still left." That would certainly be true of the Data Center and certain industrial sectors. However, Kamdem sees a bit more complicated picture for private REITs. 

Continued Hurdles for Private REITs 

When asked about the problems private REITs are facing, Kamdem responded, "I think if you think about the different asset classes, multifamily and industrial, they really have very strong fundamentals going long-term, but I think in some of these private REITs being able to offer monthly liquidity creates a scenario where you (the REIT) can be a forced seller in order to meet those redemptions." 

Kamdem expanded on the potential consequences of forced asset sales by saying, "I think that's what you want to avoid because when you're a forced seller in a tough environment, you're not going to get to participate in the upside on the back end of it when the fundamentals are recovering." 

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Two REITs Morgan Stanley and Kamdem are High On 

Kamdem specifically mentioned two REITs when asked about potential upside in 2025. The first is Regency REG, which Kamdem said is "the highest quality open-air center owner in the U.S. right now, and it trades very cheaply, at about 13.5 times earnings, phenomenal balance sheet." 

He noted, "This was one of the only companies that did not have to cut its dividend during the pandemic …. we think it's traded down too much. This is a business we think can grow at about 5% plus or minus for the next couple of years, and you get a nice 4.5% dividend." 

Kamdem is Also Bullish on Prologis 

Prologis PLD is the second REIT Kamdem believes is a potentially good buy going into 2025. Prologis recently posted strong Q2 2024 earnings and Kamdem thinks they are positioned for an even stronger performance in the future. Kamdem noted that Prologis took a hit in early 2024 when they had to lower their Q4 2023 targets, but he said, "I don't think the business fundamentals have changed long-term." 

He believes uncertainty around the election has caused leasing to slow down, but he notes that tenants haven't been giving back space. Kamdem believes 2025 has great potential because there will be a shortage of new industrial space being delivered. "The supply will be down 60-70% from the peak." He sees the economy continuing to grow at 2-3%, resulting in tenants taking back space, which will bolster Prologis’ profits.

Better Yields Than Some REITs?

The current high-interest-rate environment has created an incredible opportunity for income-seeking investors to earn massive yields, but not through publicly-traded REITs.

Arrived Homes, the Jeff Bezos-backed investment platform has launched its Private Credit Fund, which provides access to a pool of short-term loans backed by residential real estate with a target 7% to 9% net annual yield paid to investors monthly. It paid 8.1% in July. The best part? Unlike other private credit funds, this one has a minimum investment of only $100. 

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