Key Points

• With an interest rate cut likely in September, real estate’s again are worthy of investors’ attention.
• As pass-through entities, REITs offer higher dividend yields. 
• Thematic REITs like Digital Reality Trust are forecast for strong performances. 
• Also: Don’t miss out on these Two Dividend Legends to Hold Forever

Since it began raising interest rates at its March 2022 Federal Open Market Committee (FOMC) meeting, investors have been keeping an eye on the Federal Reserve in anticipation of rates finally being cut after inflation has continued to subside. When the central bank ultimately makes that decision, it will have an outsized impact on sectors sensitive to higher interest rates.

Real estate is one of them. The industry and the sector of the S&P 500 rely heavily on lending for both builders and customers, who have been subjected to the highest 30-year montage rates since the early 2000s. But come September, that’s likely to change, and investors who are aware of this can act now to capitalize on the opportunity.  

Currently, the Chicago Mercantile Exchange’s FedWatch Tool is pricing in a 100% chance of a cut for the Sept. 18, 2024, FOMC meeting, with an 85.8% likelihood of the effective federal funds rate being lowered to the 500 bps to 525 bps range. 

Welcome News for REITs

Passive income investors have long enjoyed the yields provided by real estate investment trusts (REITs). Because of their tax-advantaged pass-through structures, REITs can offer high yields as they are required by law to distribute at least 90% of their net earnings to shareholders are dividends. 

And despite these distributions often not being considering qualified dividends, their yields often make up for the fact that, for shareholders, payments are treated as ordinary income rather than capital gains.

But REITs have not received the attention other sectors have so far this year, and for good reason. While each of the S&P 500’s 11 sectors are in the green so far in 2024, real estate has lagged. The interest rate-dependent cohort has managed a meager 2.32% gain this year, which ranks it last among among all sectors. For context, the communication services sector has posted the best return for investors this year with 16.21%. 

However, viewed from another angle, it can be argued that many of the REITs operating in this space are now on sale, particularly when viewed through the lens of expectant interest rate cuts later in the third quarter of the year.

Thematic REITs

 

While all REITs take advantage of pass-through tax structures and offer elevated dividend yields, they are not all created equally. There are lingering concerns about the housing market amid an affordability crisis in the U.S., which makes residential REITs less appealing. The same goes for commercial REITs, which have suffered mightily since the arrival of the COVID-19 pandemic that saw office building vacancies skyrocket as remote work became the new normal. Therefore, companies heavily reliant on office space occupancy are equally unappealing.

But one facet of the industry is looking increasingly appealing amid a backdrop of rate cuts and increasing demand for facilities: data centers. Jumping on the cloud computing and artificial intelligence (AI) waves, demand for facilities that can house data centers is increasing exponentially compared to REITs that focus on residential, industrial or health care.

As companies’ relying on cloud computing and AI for forward growth require additional space for their data centers, REITs operating in this area will see outsized demand, which entails the construction, property management and rental of facilities offering compatible electrical systems that are able to meet energy demands, proper heating, ventilation and air conditioning (HVAC) needs and specially designed components like security and uninterrupted access. 

According to Prescient & Strategic Intelligence, the data center market size is expected to grow from $301.8 billion in 2023 to $622.4 billion in 2030, which is good for a compound annual growth rate of 10.1%. And one company in particular is positioned to take advantage of that growth forecast. 

Digital Reality Is Poised to Profit

Digital Realty Trust Inc. (NYSE: DLR) is a San Francisco-based REIT established in 2001. As of 2023, the company’s portfolio includes over 300 facilities in over 50 metro regions across more than 25 counties on six continents. So far in 2024, the stock has managed a 6.95% year-to-date gain, which has outpaced the S&P 500’s real estate sector. It also pays a dividend yielding 3.38%. For context, the average dividend yield of the S&P 500 is 1.32%.

Since July 16, shares are down 10.9%, but rather than that turning potential investors away, it should be viewed as a promising entry point based on the REIT’s financial statements and the outlook for the data center market. While Digital Realty’s most recent earnings per share (EPS) of  $0.20 failed to match analysts’ estimates of $0.27, its EPS of $.082 in the prior quarter beat expectations by 182%, and marked a 331.58% increase in year-over-year EPS for the same quarter. 

DLR’s trailing 12 month free cash flow stands at -$6.23 billion; however, that’s largely attributable to -$3.52 billion in repayment of debt. When interest rates are cut, as is expected in September, the cost of the company’s debt management will likely decrease as its free cash flow improves. That’s also likely as the company has seen year-over-year asset growth of $36.08 billion in 2020 to $44.11 billion in 2024, or a 22.25% increase. Meanwhile, its liabilities decreased from 2022 to 2023 from $23.38 billion to $23.12 billion. 

Wall Street analysts give DLR a one-year median price target of $160.50. Currently, shares are trading for $145.39, suggesting potential upside of 10.39%.

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