The bulk of real estate investment trust (REIT) businesses delivered solid results in the August’s earnings season.

Indeed, there were some bright spots reported in the fiscal 2022 results of a number of REITs.

Recovery was evident in the Vicinity Centres (ASX:VCX) fiscal 2022 result, with Australia’s largest retail REIT posting a 7 per cent increase in funds from operations to $598 million. Similarly, Arena REIT (ASX:ARF) whose portfolio includes child care centres reported strong business results with portfolio occupancy remaining at 100 per cent. And Unibail-Rodamaco-Westfiled (ASX:URW) (the operator of Westfield assets in Europe and North America) delivered an a similar strong result was achieved in its half-year result with an increase in its adjusted recurring earnings per security of EUR 4.95, putting it on track to achieve its full-year guidance of ‘at least’ EUR 8.90’ (up from EUR 6.91 in 2021).

However, the sector confronts a challenging outlook with rising interest rates.

While the earnings of REITs are predictable because of contracted earnings, they carry a lot of debt. This of course will be a risk to them amid rising interest rates.

“Lower earnings and dividends will be a reality for a number of REITS over the next couple of years. Many REITs will be impacted from the headwind of rising rates,” Morningstar analyst Alex Prineas says.

And while REITs grew their revenue in the August reporting season, for Prineas there is a question of whether revenue growth can offset rising interest rates.

Survival of the fittest

Some REITs are now achieving a strong recovery in their revenue post the health pandemic, and that revenue recovery could be enough to offset high interest costs.

“Those [retail] REITs had their income smashed because of the health pandemic. Now their revenue is recovering, and this should help to offset the headwind from rising debt costs,” Prineas says.

In comparison, the office REITs haven’t seen that recovery in incomes yet.

“We may be close to the bottom in terms of office demand, and the pipeline of new office supply looks like it will moderate” Prineas says.

Prineas noted that while interest rates didn’t have much effect on fiscal 2022 results, the effect is likely to be more pronounced on financial results, and dividends from 2023 onwards.

“Care needs to be taken because the REITs that appear cheaper, trading on high dividend yields for example, may be most at risk from rising rates,” Or on the flipside, REITs that are experiencing strong revenue growth may not have as much earnings risk, but the share prices may be expensive.

For example rental growth is tracking strongly for industrial REITs, due to retailers investing in their supply chain, and establishing ecommerce capabilities. However, valuations are very much baked in with these names now trading at elevated prices.

Morningstar does have a number of undervalued names. Three property stocks even have a five star Morningstar rating.

The star rating measures the firm’s economic moat, Morningstar’s estimate of the stock’s fair value and its confidence around the fair value estimate and the current market price. A five star stock is undervalued by a wide margin.

Premium subscribers to Morningstar will have access to these names but Prineas gives us a little peek into some of these stocks.

Lend Lease (ASX:LLC) remains on our Best Ideas list. Indeed, the businesses is well placed as governments look for opportunities to restore economic growth and construction will be key to driving this growth.

Prineas also likes Mirvac (ASX:MGR). While the environment is tough in residential housing with rising rates putting pressure on housing prices, Mirvac is also well placed in this market particularly on the competitive front.

“It’s a bit of a survival of the fittest. In the near term, rising interest rates and a declining housing market will likely make for a tough period for the group. However, we expect weaker rivals to continue to exit and Mirvac to gain market share.”

As noted, earlier, dividends will also track downwards for REITs, but Prineas reminds investors that you don’t buy a REIT based on dividend yields alone.

“REITS are not a pure income play. They are total return opportunities. Investors need to be mindful of the sector that the REIT operates in and their level of debt that each REIT has.”