Right Time to Build Positions in REIT Stocks? - Zacks Analyst Interviews

Interest rates are the dominant variable for all high-yielding asset classes and REITs offer one of the most prominent high-yield spaces. The unexpected slide in benchmark treasury yields in recent days that briefly pushed the 10-year treasury yield below the 2% mark on Wednesday has come as a welcome boost to the REITs industry. No one is talking about Fed interest rate hikes anymore; the narrative is shifting to where treasury yields will bottom.

The interest rate tailwind aside, the REITs industry's positive long-term fundamentals also increase the group's investment profile.

Opportunities in the Industry

A recent study by the CBRE Group Inc. CBG revealed a solid recovery for the U.S. commercial real estate market in the third quarter of 2014. The study says that office vacancy rates witnessed a 40 basis points (bps) sequential decline to 14.1%, denoting the steepest plunge since the second quarter of 2006. National industrial availability posted a 20 bps decline from the prior quarter to 10.6% while retail availability also moved 20 bps south for the quarter to 11.5%.

A closer look at the individual asset categories reveals that the industry is undergoing a strong transformation. In fact, amid a boom in e-commerce and online retail sales, the Retail REITs are directing all their efforts toward satisfying customers' demand for one-stop shopping, dining and entertaining as well as same-day delivery of purchases.

Moreover, with the ultimate aim of increasing traffic at their malls and seeking higher demand for space, companies like Simon Property Group Inc. SPG, General Growth Properties, Inc. GGP and Taubman Centers, Inc. TCO are embracing the omni-channel concept that essentially means selling products simultaneously through all available shopping channels.

Such a backdrop encourages us to target stocks that have a Zacks Rank #1 and 2 as these offer scope for riding on the growth trajectory. Among them are Washington Prime Group Inc. WPG, The Macerich Company MAC and Regency Centers Corporation REG.

The Industrial REITs are also exploiting the e-commerce boom. In fact, a larger customer base, rise in e-Commerce application and supply-chain consolidation is generating greater demand for logistics infrastructure and efficient distribution networks. To reduce delivery time, companies are settling near areas where the majority of the population resides.

But construction starts continue to experience a gradual pickup and vacancy rates are tightening. This is pushing the rents significantly higher in many of the U.S. and global markets. As such, stocks like Prologis, Inc. PLD and DCT Industrial Trust Inc. DCT that have a Zacks Rank #2 remain our top choices.

Then again, higher payrolls and lower construction activity are boosting the fundamentals of the Office REIT market. As an increased workforce needs more space for their accommodation, companies are renting more square feet and this is lowering the vacancy level for the office REITs.

Apart from these, there are other promising asset categories as well. Among these is Lodging/Resorts REIT which has encouraging fundamentals. Occupancy rate, revenue per available room (RevPAR) and average daily rate (ADR) are improving. More specifically, with strong lodging demand and lower supply, the West Coast remains an attractive market. Stocks that can enhance the value of your portfolio include RLJ Lodging Trust RLJ and FelCor Lodging Trust Inc. FCH.

The Healthcare REIT sub-sector, with a number of long-term leases in their portfolio, is more sensitive to interest rates. It is expected to reap near-term benefits from the prevailing low interest rate environment.

Moreover, demand for healthcare facilities and senior housing have been on the rise, with an increase in the elderly population and consequent proliferation of healthcare expenses as well as rise in new insured individuals due to the Affordable Care Act. Strong players in the market have announced acquisitions to capitalize on this trend.

Among them is Ventas Inc. VTR which has already completed the acquisition of 29 Canadian senior living communities from Holiday Retirement and is also set to buy its competitor, American Realty Capital Healthcare Trust Inc., in a stock and cash deal worth $2.9 billion. Health Care REIT, Inc. HCN acquired Gracewell assets in August and also disclosed a plan to acquire HealthLease Properties REIT for around $950 million in cash, including debt.

Residential REITs are also expected to benefit from the improvement in the economy and labor market amid underproduction in overall housing. Additionally, demographic growth continues to be strong in the young adult age cohort that has a higher propensity to rent. This age cohort has also experienced a considerable part of the net job growth and provides a significant source of pent-up demand.

Specifically, in the West Coast, improvements in the economy and job growth amid a lower supply of properties in the market keep up the demand momentum. Companies that particularly remain favorable are Avalonbay Communities Inc. AVB and Essex Property Trust Inc. ESS.

Finally, Mortgage REITs, too, are expected to benefit from the low interest rate environment. This is because mREITs usually invest in mortgages and mortgage-backed securities and use equity and debt for financing their purchases to make money from the spread. As interest rates are expected to remain low in the near to mid term, we believe that mREITs will benefit as long as the interest spread remains wide. Stocks that constitute our top choice include American Capital Agency Corp. AGNC, American Capital Mortgage Investment Corp. MTGE and Ares Commercial Real Estate Corp. ACRE.

What If Interest Rates Rise?

It is reasonable to expect interest rates to eventually rise. But as recent trends in treasury yields show, it has been a very hazardous exercise to bet on higher interest rates. While every expected 10-year treasury yields to start moving towards 3% given the end to the Fed's QE program and consensus expectations of the first rate hike in mid-2015, yields have started coming down, with references to a 1.5% benchmark yield no longer that outrageous.

That said, rates have to rise eventually in line with an improving U.S. economy. Rising rates will no doubt be a headwind for REITs, but we strongly feel that the associated economic opportunity will more than offset the higher financing cost that higher interest rates will signify.

A strong economy means elevated employment levels and companies needing more space to accommodate the new workers. Importantly, the enhanced buying power resulting from a stronger labor market would mean greater demand for rental properties. And the rise in personal income will lead to an increased frequency of shopping, dining and entertaining outside, leading to higher footfall at malls. Leisure trips and business travel would also accelerate, propelling the demand for hotels.

Bottom Line

As you can see, there are plenty of reasons to be optimistic about the REIT industry.

Check out our latest REIT Industry Outlook here for more on the current state of affairs in this market from an earnings perspective, and how the trend is looking for this important sector of the economy now.