The National Association of Real Estate Investment Trusts (NAREIT) recently released performance data for REITs. The sector has delivered a strong return this year. REITs outperformed the market in the third quarter, rising 16.8%. That continued their strong run over the past year, with the FTSE Nareit All Equity REIT Index rallying 39.1%.

That's a strong return for a sector known for paying high-yielding dividends. The average REIT currently yields around 4%, compared to less than 1.5% for the S&P 500. Here's a look at whether these high-yielding dividend stocks are still worth buying after surging in the past year.

What's driving the REIT rally?

REITs are highly sensitive to changes in interest rates. That's evident in the chart:

As that chart shows, rising interest rates since late 2021 (as measured by the rate on the 10-year Treasury) weighed heavily on REIT stock prices through late last year (REITs lost more than 30% of their value on average). However, the yield on the 10-year has declined over the past year in anticipation of the Federal Reserve cutting the federal funds rate, which it finally did last month. That helped spark a surge in REIT stock prices, especially over the past quarter.

The rally in the REIT sector has been fairly widespread. The only sectors that haven't participated in the rebound this year are industrial, lodging/resort, and timberland REITs, which are more economically sensitive. Meanwhile, the biggest return has come from specialty REITs, which have rallied 50% this year.

That's largely due to the surge in Iron Mountain's (NYSE: IRM) stock price. The information storage REIT has seen its stock price more than double over the past year. Its Project Matterhorn is really paying dividends by driving accelerated revenue and earnings growth for the REIT.

Can REITs continue to recover?

Despite their rally over the past year, most REITs still trade well below their peaks from early 2022, which was right before the Fed started raising rates. For example, leading net lease REIT Realty Income (NYSE: O) currently sits more than 20% below its high from a few years ago. Because of that, it still offers an attractive 5% dividend yield. While higher interest rates have acted as a headwind for Realty Income in recent years, the REIT has still managed to continue its unbroken streak of dividend increases (108 straight quarters).

The company expects to grow its adjusted funds from operations (FFO) at a 4% to 5% annual rate in the future as it continues to acquire income-producing real estate. Because of that, Realty Income can produce a solid total return (9% to 10% annualized), even if its valuation doesn't return to its peak from a few years ago. Meanwhile, there's additional upside potential if its valuation does continue to improve.

Top-tier REITs Federal Realty Investment (NYSE: FRT) and Prologis (NYSE: PLD) also still trade at a more than 20% discount to their peak levels from early 2022. Both REITs are arguably stronger today than they were back then.

Federal Realty is seeing record leasing across its retail portfolio as retailers continue seeking high-quality locations, which is driving steady rent growth. The retail REIT also continues to invest in expanding its portfolio (it recently bought two assets for $275 million and is investing $840 million into redevelopment and expansion projects). These growth drivers have enabled the REIT to continue extending its industry-leading dividend growth streak (57 straight years).

Prologis is capitalizing on robust demand for its warehouse properties, which is keeping occupancy levels high and driving strong rent growth. The leading industrial REIT has also invested heavily to expand its portfolio (it bought rival Duke Realty in a highly accretive $23 billion deal in 2022). In addition, it has invested to develop new warehouses and expand into the fast-growing data center development market.

Despite interest rate headwinds, Prologis has delivered 13% compound annual core FFO per share growth and 14% annual dividend growth over the last three years. With significant growth still ahead, the REIT has strong total return potential from here.

This red-hot sector still has room to run

REITs have rallied sharply over the past year, largely thanks to the expectation of falling interest rates. With the Federal Reserve finally starting to cut rates (and more reductions likely), REITs should have more room to rally.

Several high-quality REITs remain well below their peaks from a few years ago, even though they've thrived amid higher rates. Because of that, the sector still looks enticing, especially for those seeking to collect some income with their upside potential.

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Matt DiLallo has positions in Iron Mountain, Prologis, and Realty Income. The Motley Fool has positions in and recommends Iron Mountain, Prologis, and Realty Income. The Motley Fool recommends the following options: long January 2026 $90 calls on Prologis. The Motley Fool has a disclosure policy.

These High-Yield Dividend Stocks Have Rallied Nearly 40% Over the Past Year. Is it Too Late to Buy? was originally published by The Motley Fool