Rising interest rates are generally a negative catalyst for real estate stocks. Without getting too deep into an economics lesson, the general idea is that when risk-free interest rates (like Treasury securities) rise, yields of other income investments like real estate investment trusts, or REITs, tend to rise as well. Since price and yield have an inverse relationship, this puts pressure on REIT prices.
In fact, since the start of 2022, just before the current rate-hike cycle started, the real estate sector as a whole has generated a negative 15% total return, compared with a positive 24% from the S&P 500 in the same period. However, with rates largely expected to start falling later in 2024, the next few years could be a completely different story.
Both EPR Properties (NYSE: EPR) and Realty Income (NYSE: O) have moved higher recently as more investor attention has turned to dividend-paying stocks, but they are still trading for 48% and 30%, respectively, below their all-time highs set shortly before the COVID-19 pandemic hit. And now could be a great time for long-term investors to take a look at these excellent income stocks before interest rates start to fall.
Movie theater exposure and a tough growth environment
EPR Properties is a REIT that specializes in experiential properties -- that is, businesses that sell experiences rather than physical products. For example, TopGolf is one of EPR's largest tenants, and other property types include waterparks, ski resorts, and family entertainment centers. And, of course, the biggest cause for investor concern is movie theaters, which make up nearly 40% of EPR's rent.
However, I believe the fears about EPR's theater exposure are overblown. After all, EPR's theaters tend to be in excellent locations and profitable for their operators. In fact, the company's third-largest tenant, Regal Entertainment's parent company, recently declared bankruptcy, but emerged from it and signed a new lease in a favorable manner for EPR.
The company is actively looking for opportunities to diversify the portfolio away from theaters, both by strategically selling properties and by acquiring other types of properties. Management sees a $100 billion investable universe of experiential properties, and the company has an excellent balance sheet that should allow it to pursue attractive opportunities -- especially if interest rates come down. In the meantime, investors receive a well-covered 7.7% dividend yield paid in monthly installments and a highly profitable business.
A time-tested model at a big discount
Realty Income has been around since 1969 and has evolved into one of the largest REITs in the world. It owns over 15,400 properties throughout the United States and Europe. Most of its properties are freestanding retail, although there are industrial, agricultural, and gaming properties in the portfolio as well.
Don't worry too much about the retail exposure . The properties are typically bought with high-quality tenants already in place, and these tenants sign long-term (10+ years) leases with gradual rent increases built in. Not only that, but most of the tenants are in industries that are naturally recession-resistant and aren't too susceptible to e-commerce headwinds.
While retail real estate might not sound like the most exciting business, you might be surprised at how consistently strong its returns have been. Since going public in 1994, Realty Income has generated 13.6% annualized returns, handily beating the S&P 500. The stock not only has a 5.7% dividend yield but has increased its dividend for the past 107 quarters in a row .
Two great income stocks with tons of upside
Both EPR Properties and Realty Income could be big winners as interest rates start to come down. Not only would lower interest rates put upward pressure on income investment valuations, but they would make it more cost-effective for REITs to borrow money to grow, and increased consumer confidence could be a tailwind for both companies' tenants.
To be clear, I own both stocks in my portfolio, and I think they're great long-term investments that I've been accumulating for years. Now looks like an attractive time to take a closer look.
Matt Frankel has positions in EPR Properties and Realty Income. The Motley Fool has positions in and recommends Realty Income. The Motley Fool recommends EPR Properties. The Motley Fool has a disclosure policy .
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