2024 Analyst Outlook: Jussi Askola On Being Selective With REITs, Dividend Investing (2024)

The big hits taken by REITs, with the investment sector down 22% since 2022, may present an opportunity for investors entering 2024.

But those looking at REITs need to be selective, according to Seeking Alpha analyst and Investing Group leader Jussi Askola, a sentiment that he shares not only with this sector but also generally with dividend investing.

The areas presenting opportunities: Apartment communities, net lease, cell towers and healthcare properties among REITs, and utilities, renewable energy and infrastructure plays among dividend ideas. The areas to avoid: Mortgage REITs, offices, self-storage and data centers among REITs, and some business development companies for dividend investments.

Askola presents his 2024 perspective below:

Seeking Alpha: Before we get into why you think REITs will deliver for investors in 2024, we think it would be of value to hear some of your observations on why REITs have underperformed the market in 2023. Are the reasons for the underperformance justified?

Jussi Askola: The surge in interest rates had a greater negative impact on the market sentiment of REITs than other stocks and that's why REITs underperformed for most of 2022 and 2023:

Note that I referred to market sentiment, and not to fundamentals, and that's because REITs kept performing quite well from a fundamental perspective.

The high inflation of recent years led to rapid rent growth, and since REITs use relatively little leverage (35% average LTV) and have long debt maturities (eight years on average), the negative impact of rising interest rates wasn't significant in most cases.

Put simply, the positive impact of inflation was greater than the negative impact of rising interest rates, and as a result, cash flows and dividend payments have kept on rising in the REIT sector.

This also has been true in past cycles of rising interest rates, and it explains why REITs have historically generated strong positive returns and even outperformed the S&P 500 (NYSEARCA:SPY) in the 12 months following rate hikes:

So why was this time different?

I believe that what happened is that when interest rates were ultra low, a lot of investors ended up buying REITs as bond replacements to earn income, but they had no interest in holding REITs for the long run.

Therefore, as soon as interest rates returned to more reasonable levels, they sold their REITs, irrespective of their strong fundamentals, and reallocated their capital into fixed-income alternatives, causing REITs to underperform other stocks.

The odd thing is that a lot of sectors like tech stocks are today priced at near all-time highs as if the surge in interest rates had no impact on them, but in reality, those stocks should be even more heavily affected than REITs given the long duration of their cash flows.

When you increase discount rates in valuation models, it's the profits that are expected far into the future that decrease the most in value. Therefore, growth stocks that generate little profits today but are expected to generate lots of profits in 5-10 years from now probably should have seen their share prices drop a lot more than they have. On the contrary, REITs and other companies that generate a lot of profits today and are priced at reasonable multiples of today's cash flow should have been more resilient.

Therefore, I think that the recent underperformance of REITs is an opportunity and it sets them up for strong outperformance going forward.

SA: Why REITs in 2024? Why do REITs present an opportunity for investors? And what REIT sectors present the best opportunities (and the ones to avoid)?

JA: The REIT sector is down 25% on average since 2022 even as most REITs grew their cash flows by 5%-10% and created additional value by paying off debt, buying back shares, and acquiring more properties. As a result, their valuations are today near their lowest level in a decade with lots of individual REITs trading at low multiples of their cash flow and large discounts relative to their net asset values:

We know that this crash occurred because of rising interest rates, and therefore, we think that REITs should strongly recover as interest rates return to lower level.

The Fed just recently indicated that we should have at least three interest rate cuts this year, and most major banks, including Goldman Sachs (GS), Morgan Stanley (MS) and UBS (UBS), are expecting even steeper rate cuts. FedWatch is now pricing a 99.9% chance of at least one rate cut by June 2024:

This sets REITs for a strong recovery, and we just recently saw a quick glimpse of that as REITs surged when expectations shifted to lower interest rates:

But I think that this is still just the beginning.

Right now, there are lots of income-driven investors who are still happily hiding in 5% yielding money market funds and short-term Treasuries because interest rates have not yet been cut.

But once the cuts actually occur, investors will realize that the 5% yield was really just a mirage and I expect a lot of the capital that left REITs to come right back into them.

I think that the best opportunities are in the property sectors that were the most beaten down by fears of rising interest rates. Typically, those are REITs that invest in apartment communities, net lease properties, ground leases, cell towers, and healthcare properties. Right now, there are lots of individual REITs that are still down 30%, 40%, or even 50%, and this means that the upside potential could be very significant in the coming years.

I'm avoiding a few property sectors that are suffering secular threats, overbuilding, and/or are already fully priced. This includes office buildings, self-storage, and data centers.

SA: Moving more broadly into dividend ideas… how should dividend investors position themselves for 2024? Will it become challenging to find the right opportunities?

JA: Based on what I'm reading on Seeking Alpha and elsewhere, it seems that a lot of investors are today tempted to sell and take gains following the recent rally in dividend stocks.

REITs, utilities, BDCs, renewable energy stocks and other higher-yielding sectors are all up significantly over the past two months and this is causing investors to think that prices have run up too much too fast.

But it's important to zoom out a bit.

This rally was really just the recovery from the dip that occurred in October, and generally valuations remain low in most of these sectors:

Therefore, I think that it's a mistake to sell so early into the recovery.

I of course don't have a crystal ball and can't predict how any of these stocks will perform over the short run, but I'm quite confident that the recovery will continue over the coming years and the expected returns should be quite strong.

For these reasons, I remain fully invested and continue to gradually buy more dividend stocks like REITs whenever new capital becomes available. As of right now, we're not having any trouble finding opportunities.

SA: Are there certain sectors for dividend investors to look at in 2024? Sectors to avoid?

JA: I already discussed REITs at length because that's where I'm finding the best opportunities at the moment. They're particularly heavily discounted and the anticipated rate cuts should be a particularly strong catalyst for them.

A similar opportunity exists today in utilities. A lot of them also are beaten down and offer great value for your money and a path to significant appreciation in the coming years.

Renewable energy and other infrastructure companies also are heavily discounted for the same reasons and offer historically high dividend yields and upside potential.

But not all dividend stocks are worth buying, and just because something has dropped significantly does not necessarily mean that it's cheap.

Mortgage REITs are a great example of that. I have stayed away from them for years because I believe that most of them are uninvestable. After all, their businesses are completely at the mercy of unpredictable macro factors such as spreads and interest rates. Today, many of them are heavily discounted, but over the long run, their performance has been very disappointing and I don't see that changing.

Another higher-yielding sector that I'm careful about is business development companies (BDCs). There are some individual companies that are interesting, but most of this sector has already recovered and has less to offer, especially as interest rates return to lower levels and we potentially head into a recession. This should lead to lower interest income since most of their loans have variable rates, and a recession could lead to greater loan defaults.

So in short, I'm today favoring dividend stocks that own real assets such as properties, energy pipelines, and infrastructure, and are discounted due to fears of rising interest rates.

SA: Your economic outlook for 2024. The markets finished 2023 at near-record highs. Should investors be wary of what to expect in the year ahead?

JA: I will start here by saying that I think it's impossible to make one-year predictions. It's just too short of a time frame and there are too many moving pieces.

• How much will interest rates be cut?
• What happens with the election?
• Do we get another spike in inflation?
• Will we enter a recession in 2024?
• Does Russia continue its invasion and cause further chaos in Europe?
• Will the war continue to spread in the Middle East?

A lot of analysts will pretend that they know the answers to these questions and make short-term stock market predictions, but this is nothing more than wishful thinking, in my opinion.

So my answer is that I have no clue and I openly admit that I don't know how the market will perform in 2024.

With that said, I'm very optimistic about the multi-year prospects of beaten-down sectors like REITs.

This is simply because their valuations are historically low, their balance sheets are the strongest they have ever been, and their assets are absolutely essential to the survival and prosperity of the human race. There are exceptions of course, but you don't need to be a genius to understand that a well-located apartment community with growing rents that's conservatively financed and bought at a 40% discount to its fair value is likely to be a good investment over the long run.

Therefore, instead of worrying about the short term, which is always unpredictable, I think like a landlord and focus on the expected returns over the next 5-10 years. Today's valuations and fundamentals give me good reasons to be bullish.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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