REIT Industry Review And Stock Picks - February 2014

The year 2013 has been an unusual one for the Real Estate Investment Trust (REIT) industry, with stock prices of this special hybrid asset class seeing both highs and lows. Particularly, the concerns surrounding the interest rate environment emanating from the Federal Reserve’s economic stimulus moves kept the industry in the headlines in the second half of the year.

And for the first time in five years, the listed U.S. REIT stocks’ return underperformed the broader equity market as per the National Association of Real Estate Investment Trusts (NAREIT). On a total return basis in 2013, the FTSE NAREIT All REITs Index climbed just 3.2% compared to the S&P 500’s decent 32.4% run.

Finally, convinced by the consistent pickup in economic activity and labor market improvement, the Fed started tapering its stimulus in December. Further, in January, the Fed cut its monthly bond buying to $65 billion from $75 billion in December.

In spite of this stance taken by the Fed, recent economic data have not been as robust as expected. Coupled with the emerging economy woes, the benchmark indices in fact became volatile resulting in a soft start to this year.

REITs Back in Focus

With this backdrop, the focus again shifted to REITs, which more often than not, tend to perform better when stocks from other industries are down. On a total return basis, the FTSE NAREIT All REITs Index gained 3.4% in January, compared to the S&P 500’s decline of 3.5%.

While the gradual reduction in the Fed’s support could lead to higher interest rates in the long run, thereby hurting the rate-sensitive business of REITs, we believe that broader market concerns will not cart off the prospects of gaining from portfolio diversification that this distinct asset class offers.

REITs, which basically own and manage income-producing real estate (such as apartments, offices, hotels, industrial or other facilities or invest in mortgages or mortgage-backed securities attached with properties), let its shareholders enjoy ownership benefits of the real estate without actually becoming landlords.

These assets perform differently based on individual market dynamics. Therefore, investors have the opportunity to gain maximum leverage from the changes seen time to time in performances by these assets.

Consumer Confidence Growing

A decent GDP report and encouraging U.S. retail data clearly indicate growing consumer confidence, which is further reinforced by the Fed’s new-found faith in the economy.  Also, the Conference Board data shows an improvement in the Consumer Confidence Index to 80.7 in Jan 2014 from 77.5 in Dec 2013 – reflecting an increase for the second successive month and implying a steady rise in consumer spending.

With consumer spending accounting for over two-third of the U.S. economic activity, we believe that this is an opportune moment for those companies that provide real estate support to the sectors which directly benefit from these activities. And with the Fed intending to keep the interest rates near zero, despite the tapering and until unemployment rate drops below 6.5%, REITs will continue to benefit.

Dividends Still Key Attraction

Dividends continue to be the key attraction of this industry. With the U.S. law requiring REITs to distribute 90% of their annual taxable income in the form of dividends to shareholders, yield-hungry investors still have a large appetite for such stocks. This has enabled the industry to stand out and gain a footing over the last 15–20 years.

As of Jan 31, the dividend yield of the FTSE NAREIT All REITs Index was 4.16%. The yield of the FTSE NAREIT All Equity REITs Index was 3.65% while the FTSE NAREIT Mortgage REITs Index yielded 9.73%. Clearly, the REITs continued to offer solid yields and outpaced the 2.09% dividend yield offered by the S&P 500 as of Jan 31.

Capital Access

Accessibility to capital is a prime factor in the REIT industry and the year 2013 has been a notable one from this angle. A total of $76.96 billion was raised by listed REITs compared to $73.33 billion in the prior year. A solid IPO market in 2013 primarily made it happen. During the year, 19 IPOs helped in raising a total of $5.71 billion, marking the highest amount raised in the largest number of IPOs since 2004. REITs have further raised $4.4 billion in initial, debt and equity capital offerings in Jan 2014.

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 plus 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 - Retail is #94, REIT Mortgage Trust is #100, REIT Equity Trust - Residential is #108 and REIT Equity Trust - Other is #168. Analyzing the Zacks Industry Rank for different REIT segments, it is obvious that the outlook for REIT industry as a whole is in the neutral zone.

Earnings Trends

Currently, we are in the last leg of the fourth quarter 2013 earnings season with results from 430 S&P 500 companies already declared. These companies account for 91.3% of the index’s total market capitalization.

As a matter of fact, in 2013, the broader Finance sector, of which REITs are part, has marched well to get back its top position in terms of earnings contribution in the index. Among the finance companies that have already reported (94.9% of the S&P 500’s Finance sector), the ‘earnings beat ratio’ (percentage of companies with positive surprises) was 72.0% while the ‘revenue beat ratio’ was 64.0%.

Total earnings for this sector were up 22.8% year over year and as against a 10.5% growth in the third quarter. On the other hand, total revenue moved south 8.8% year over year verses a decline of 14.6% in the prior quarter.

But consensus earnings expectation for the upcoming quarters remain weak with an anticipation of a decrease in year-over-year earnings of 8.4% in first quarter 2014, 7.6% in the second quarter and 1.0% in the third. But 2014 earnings are expected to increase 6.6% from the prior year.

OPPORTUNITIES

Retail REITs

Growing consumer confidence drives the demand for retail goods. Consequently, this is an opportune moment for companies providing real estate support to the retail sector. Amid lower supply of new properties, steadily rising demand is shaping up as the sector’s growth driver for years to come.

As per recent analysis by the commercial real estate services firm CBRE Group, Inc. (CBG), the retail availability rate fell 30 bps to 12.0% for the fourth quarter and moved 70 bps down for 2013, reflecting consistent improvement in net absorption. CBRE’s outlook of a further drop in the availability rate for neighborhood and community shopping centers to 10.6% in 2014 is added good news for the sector.

Moreover, with competition intensifying from a growth of e-commerce, product delivery to customers has become a major zone for combat for the mall REITs. As a result, retail REITs such as Simon Property Group Inc. (SPG), The Macerich Company (MAC) and General Growth Properties, Inc. (GGP) are leveraging on their nationwide real estate properties – mall and retail outlets – and using these as distribution centers. They are using their infrastructure with Deliv’s solution to offer same-day delivery service to retailers. With the stores already having a presence in the cities and in the vicinity of target customers, delivery of items can be speedy as well.

Considering the current operating environment and the company fundamentals, we are positive on stocks like Excel Trust, Inc. (EXL), Federal Realty Investment Trust (FRT), Inland Real Estate Corp. (IRC), Simon Property Group Inc. and National Retail Properties, Inc. (NNN).

Industrial REITs

Higher automotive purchases and overall consumer spending in recent times, which is essentially a reflection of a healthy recovery in industrial production, is encouraging and is expected to drive the demand for industrial real estates going forward. Moreover, a larger customer base, rise in e-Commerce application and supply chain consolidation are generating greater demand for logistics infrastructure and efficient distribution networks.

And amid low industrial new construction activity, we believe the current owners of such properties would be able to leverage from it and drive up their profitability in a number of quarters ahead.

Hence, these REITs that own or manage properties for industrial needs such as bulk warehouses, self-storage facilities, distribution facilities and light industrial facilities, are enjoying a favorable trend in U.S. industrial absorption. As such, stocks like STAG Industrial, Inc. (STAG), Public Storage (PSA) and Sovran Self Storage Inc. (SSS) look promising.

Lodging/Resorts REITs

Encouraging fundamentals in the lodging industry are expected to drive RevPAR (revenue per available room) growth and improve operating results in the West Coast. The pace of group booking for 2014 is favorable, reflecting better business while supply growth in the West Coast is expected to be pretty slow.

Pricing is, therefore, anticipated to rise on limited supply and rising demand. Stocks worth a look include Host Hotels & Resorts, Inc. (HST), Pebblebrook Hotel Trust (PEB) and RLJ Lodging Trust (RLJ).

On the other hand, though supply in the West Coast is low, an expected rise in supply in the East Coast in the upcoming quarters may drag the recovery of the market. Particularly, it is anticipated that the New York market will face high levels of supply while the overall market in Washington DC will continue to encounter headwinds in 2014.

Healthcare REIT

These REITs are likely to benefit from the projected 6.1% rise in national health expenditures in 2014 and 5.8% in 2015, according to Centers for Medicare and Medicaid Services. Also, the federal agency projects health expenditures to see compounded annual growth rate of 6.2% over 2015 through 2022.

In fact, the healthcare industry is estimated to account for 18.3% of U.S. GDP in 2014, thereby providing ample opportunity for the real estate companies supporting healthcare facilities to grow and enhance profitability.

Apart from this, the rising senior citizen population is expected to be a boon for the healthcare sector as this age group spends 200% more than the average population on healthcare.

Also the expected rise in new insured individuals due to the Affordable Care Act would not only enhance the demand for healthcare facilities, but also for properties offered by healthcare REITs. In particular, the demand for medical office buildings is expected to get a boost.

Therefore, we currently foresee Healthcare REITs like Sabra Health Care REIT, Inc. (SBRA), Healthcare Trust of America, Inc. (HTA), Omega Healthcare Investors Inc. (OHI), HCP Inc. (HCP) and Ventas Inc. (VTR) capitalizing on this trend.

But skilled nursing facilities would continue to bear the risk associated with government reimbursements and increasing supply in senior housing could lower the near to mid-term growth tempo in rent and occupancy to some extent. 

REIT Mortgage Trust

Mortgage REITs (commonly known as mREITs) invest in mortgage-backed securities and use short-term debt for financing their purchases to make money from the spread. In the past couple of years, with low short-term rates and Fed policies, mREITs have benefited from lower borrowing costs, leading to higher yields.

Though volatility in interest rates and mortgage spreads largely impacted the results of mREITs in 2013, these companies are adjusting their strategies, business model and shifting focus on shorter maturity securities.

But with expectations for short-term interest rates remaining low and the Fed stance supporting that view, we believe that mREITs would benefit as long as this interest spread remains wide and investors can leverage this opportunity. Companies that remain favorable are Capstead Mortgage Corp. (CMO), Blackstone Mortgage Trust, Inc. (BXMT), Five Oaks Investment Corp. (OAKS), Hatteras Financial Corp. (HTS) and MFA Financial, Inc. (MFA).

Residential REIT

The economy and the 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. They are renting at much increased rates than the past cycles as over the past few years, this age cohort has experienced a considerable part of the net job growth.

Moreover, with a solid percentage of this age group still remaining with their parents, this age cohort is expected to provide a significant source of pent up demand, which might come to the market with an improvement in the economy. Yet, in the near term, rise in supply due to delivery of a number of projects following completion could limit rent growth as more companies seek occupancy.

Therefore, considering the market environment and growth prospects we are positive on stocks like Associated Estates Realty Corp. (AEC), Education Realty Trust, Inc. (EDR), Avalonbay Communities Inc. (AVB) and Equity Residential (EQR).

WEAKNESSES

Expected increase in interest rates will lead to steeper interest costs as REITs look for both fixed and variable rate debt financing to pay back maturing debt and fund its development and redevelopment activities. In addition, amid rising interest rates, the common stock buyers demand a higher dividend yield which may negatively impact the market price of shares.

Segment wise, while the Office REITs have just started to benefit from the growth in jobs and lower new supply, the pace of improvement is expected to be tepid as a result of the space efficiency strategies adopted by companies. Moreover, conditions remain choppy for the Washington, D.C. office market, with slow leasing activities and weak rental rate.

Also, we note that companies like Mack-Cali Realty Corp. (CLI) have started to trim their office properties and diversify into the relatively stable multifamily apartment sector.

Conclusion

Despite the interest rate issues, we believe that with the economic recovery gaining momentum and activities picking pace, an opportunistic investment in REITs should not disappoint over the long run.

Original post