REITs: Something to Build On - Industry Outlook

For those investors who've lost their appetite for Real Estate Investment Trust (REIT) stocks, the impact of encouraging economic indicators over the past five months should act as an enticement. After bouncing back from a lackluster 2013, this special hybrid asset class pulled in their capital and scored well on the return book.

As per the National Association of Real Estate Investment Trusts (NAREIT), the FTSE NAREIT All REITs Index climbed a decent 14.8% against the 5.0% increase in the S&P 500 Index, from January through May.

Proving their mettle, REITs are again performing better than other stocks -- a feature that makes their addition to your portfolio a strategic one. Sidestepping interest rate issues and the Fed policy, REITs have shifted their focus to overall economic improvement, demand-supply dynamics and the corresponding impact on the rental rates and occupancy levels.

Even if increase in interest rates hold back the industry's growth, economic betterment will lead to improved disposable income, higher occupancy levels and rent, rise in property valuation, and finally improvement in total income and dividend level.

As REITs are usually owners and managers of different types of properties (like malls, shopping centers, apartments, offices, hotels, industrial or other facilities), shareholders not only enjoy ownership benefits of the real estate without actually becoming landlords, they also seek opportunities to gain maximum leverage by focusing on the individual market dynamics of these different asset types.

Economic Activity Picking Up

After a cold snap and contracted growth in the first quarter, the sun is again shining on the economy and consumer optimism is back. Impressive data across manufacturing to employment is raising hopes for the second quarter and rest of the year.

With an uptick in consumer confidence (Index reached 83.0 in May, up from 81.7 in April) and consumer spending accounting for over two-third of the U.S. economic activity, we believe this is an opportune moment for those companies that offer real estate support to the sectors which directly benefit from these activities.

On the other hand, as construction is still at a comparatively low level, we foresee limited supply in the near to medium term. And coupled with the Fed's intention of keeping the interest rates near zero, despite tapering, until sufficient improvements are achieved in terms of unemployment rate and inflation, we expect the REIT industry to be on a roll.

Dividends Still Key Attraction

In addition to capital appreciation, yield-hungry investors continue to have a large appetite for REIT stocks as the U.S. law requires these to distribute 90% of their annual taxable income in the form of dividends to shareholders. This unique feature made the REIT industry stand out and gain a solid footing over the past 15–20 years.

As of Apr 30, the dividend yield of the FTSE NAREIT All REITs Index was 4.05%. The yield of the FTSE NAREIT All Equity REITs Index was 3.57% while the FTSE NAREIT Mortgage REITs Index yielded 9.80%. Clearly, the REITs continued to offer solid yields and outpaced the 2.07% dividend yield offered by the S&P 500 as of that date.

Capital Access

Accessibility to capital is a prime factor in the REIT industry and the recent capital market activities gives cues of a rise in investor confidence in this sector and their willingness to pour in their hard earned money into it. As of Apr 30, REITs raised $17.6 billion in initial, debt and equity capital offerings in 2014.

Also, 2013 was notable from this angle with listed REITs raising a total of $76.96 billion compared with $73.33 billion in the prior year. The increase was backed by a solid IPO market last year.

Zacks Industry Rank

Within the Zacks Industry classification, REITs are broadly grouped into the Finance sector (one of 16 Zacks sectors) and further sub-divided into four industries at the expanded level: REIT Equity Trust - Retail, REIT Equity Trust - Residential, REIT Equity Trust - Other and REIT Mortgage Trust.

We rank all of the 260 industries in the 16 Zacks sectors based on the earnings outlook for the constituent companies in each industry. This ranking is available on the Zacks Industry Rank page.

As a point of reference, the outlook for industries with Zacks Industry Rank #88 and lower (the top one-third of the list) is 'Positive,' between #89 and #176 is 'Neutral', and #177 and higher (the bottom one-third) is 'Negative.'

The Zacks Industry Rank for REIT Equity Trust - Other is #84, REIT Equity Trust - Residential is #95, REIT Mortgage Trust is #107 and REIT Equity Trust - Retail is #161.  Looking at the Zacks Industry Rank for different REIT segments, it is obvious that the outlook for REIT industry as a whole is in the positive-to-neutral zone.

Industry Performance

Retail REITs: Leaving behind the concerns of lesser footfall in the brick and mortar shops amid a boom in e-commerce and online retail sales, the retail REIT sector has geared up with moves to satisfy customers' demand for one-stop shopping, dining and entertainment and finally have their purchases delivered to their homes on the same day.

Their ultimate aim is to see higher demand for their space and therefore, these firms are transforming their boring shopping hubs into swanky entertainment zones and distribution centers as well as embracing latest technologies to offer attractive services to its tenants and mall visitors. Finally, that would only help in increasing the traffic.

Industrial REITs: The Industrial REIT class is also exploiting the e-commerce boom. In fact, an improving economy, higher consumer spending and rise in e-Commerce application is generating greater demand for logistics infrastructure and efficient distribution networks.

Moreover, companies are seeking consolidation of distribution networks and are settling near densely populated areas. This not only helps to serve customers better but also cuts down on delivery time. Therefore, we expect the current owners of such properties to leverage from limited supply and drive up their profitability in the quarters to come.

Lodging/Resorts REITs: Encouraging fundamentals in the lodging industry are expected to drive RevPAR (revenue per available room) growth. The solid performance that the properties on the West Coast put up in the first quarter is expected to continue through 2014. With strong lodging demand and lower supply, the West Coast remains an attractive market.

While supply in the West Coast is low, the expected rise in supply in the East Coast in the upcoming quarters may drag the recovery of the market. Also, markets like Washington DC remain our concern.

Healthcare REIT: With a number of healthcare REITs having long-term leases for their portfolio, this sector is more sensitive to interest rates. While there are minor issues, this sector is expected to reap near-term benefits from the prevailing low interest rate environment.

A growing aged population, increasing national healthcare expenditures and expected rise in new insured individuals due to the Affordable Care Act provide ample opportunities for the real estate companies and in turn help healthcare facilities to grow and enhance profitability. The demand for medical office buildings, in particular, is expected to get a boost. But skilled nursing facilities would continue to bear the risk associated with government reimbursements.

REIT Mortgage Trust: These REITs – usually referred to as mREITs – invest in mortgages and mortgage-backed securities and use equity and short-term debt for financing their purchases to make money from the spread. While mREITs befitted from low short-term rates and Fed policies in the past that led to lower borrowing costs and higher yields, volatility in interest rates and mortgage spreads significantly affected their results in 2013.

These companies naturally started adjusting their strategies, business model and shifting focus to shorter maturity securities., As short-term interest rates are likely to remain low and the Fed stance supporting that view, we believe that mREITs will benefit as long as this interest spread remains wide. However, these REITs bear long-term risk as interest rates will eventually rise.

Residential REIT: The economy and labor market are expected to improve amid underproduction in overall housing. Apart from this, demographic growth continues to be strong in the young adult age cohort, which has a higher propensity to rent. This age cohort has experienced a considerable part of the net job growth.

According to a study by the commercial real estate services firm CBRE Group, Inc. (CBG) published in April, the national apartment demand is currently growing at a stronger pace (over 220,000 units or 1.6% on an annual basis) than what the market observed historically. This makes us confident of better growth prospects for this REIT class. But as a number of projects reach completion and start delivery in the near term, rent growth could be thwarted by more companies seeking occupancy.

Office REITs: The office REITs have started to benefit from the recovery in the economy, growth in jobs and lower new supply. Private sector employment growth is likely to drive the revival, pushing vacancy levels lower.

But the pace of improvement is expected to be tepid, owing to the lack of any strong demand catalyst as well as space efficiency strategies embraced by companies. Moreover, conditions remain choppy for the Washington, D.C. office market, with slow leasing activities, elevated vacancy levels and a weak rental rate.

Earnings Trends

The Q1 earnings season is finally concluding, and the focus has now shifted to the expectations for the next quarter and the rest of the year.

The broader Finance sector, of which the REITs are part, weighed down on aggregate growth in the first quarter, after being a significant contributor to growth for several quarters. But real estate companies stand tall.

This becomes quite evident when we take a peek into the scorecard in terms of the Finance sectors' component medium-level (or M-level) industries.

The broader Finance sector witnessed a decline of 7.2% in earnings and 1.1% in revenues in Q1, mainly due to the weak performance by Banks - Major, Banks and Thrifts as well as Insurance. But Real Estate's earnings grew 18.7% while revenues moved 10.5% north.

Similarly, though the consensus earnings growth expectation remains low (-2.0% for Q2, 5.0% for Q3 and 11.0% for Q4) for the broader Finance Sector, the same for Real Estates are quite encouraging (104.1% for Q2, 170.1% for Q3 and 195.9% for Q4).

OPPORTUNITIES

Amid an improving economy, growing demand and limited supply we believe this is an opportune moment to enhance your portfolio with a number of REIT stocks having strong fundamentals and growth opportunities.

Specific REITs that we like with a Zacks Rank #1 (Strong Buy) include Spirit Realty Capital, Inc. (SRC), Chatham Lodging Trust (CLDT), The GEO Group, Inc. (GEO), Terreno Realty Corp. (TRNO), Capstead Mortgage Corp. (CMO) and Walter Investment Management Corp. (WAC).

Stocks in the U.S. REIT universe with a Zacks Rank #2 (Buy) currently include Equity LifeStyle Properties, Inc. (ELS), Acadia Realty Trust (AKR), Retail Properties of America, Inc. (RPAI), Host Hotels & Resorts, Inc. (HST), SL Green Realty Corp. (SLG), Pebblebrook Hotel Trust (PEB) and Extra Space Storage Inc. (EXR).

WEAKNESSES

Despite the economic recovery, we believe that a number of stocks would remain under pressure for their weak fundamentals and lesser growth opportunities. Moreover, an anticipated increase in interest rates in the long term would also lead to steeper interest costs as the REITs look for both fixed and variable rate debt financing to pay back maturing debt and fund its development and redevelopment activities.

Specific REITs that we don't like with a Zacks Rank #5 (Strong Sell) are American Realty Capital Properties, Inc. (ARCP), Getty Realty Corp. (GTY), Winthrop Realty Trust (FUR), Blackstone Mortgage Trust, Inc. (BXMT) and ZAIS Financial Corp. (ZFC).

We also don't recommend a few Zacks Rank #4 (Sell) REITs including UMH Properties Inc. (UMH), Starwood Property Trust, Inc. (STWD), PS Business Parks Inc. (PSB), EPR Properties (EPR) and Pennsylvania Real Estate Investment Trust (PEI).