REIT Industry Review And Stock Picks - October/November 2013

REIT as an Asset Class

A Real Estate Investment Trust (REIT) is a company that owns and manages income-producing real estate such as apartments, offices, hotels, industrial or other facilities. Such companies also invest in mortgages or mortgage-backed securities attached with properties. REIT shareholders enjoy ownership benefits of the real estate without actually becoming landlords.

This hybrid asset class offers capital appreciation along with yield, thereby adding diversity to ones equity portfolio and assuring competitive long-term returns. It also provides a hedge against inflation.

Industry Performance So Far This Year

The U.S REIT industry has been on a roller coaster so far this year. After a remarkable run in the first four months, the sector nosedived in May, as rising interest rates and skepticism about the Fed’s Quantitative Easing (QE) program spread caution in the market. The apprehensions spilled over to August.

But around mid-September, the REIT stage was again set for action with the Fed’s ‘no taper’ decision and lower GDP projections for 2013 and 2014, which indicated a continued low interest rate environment in the near term.

As a result, the REIT stocks rallied the most and outperformed the S&P 500. On a total return basis, the broadest U.S. REIT Index -- FTSE/NAREIT All REIT Index -- gained 3.55%, outpacing 3.14% growth for the S&P 500 in September. Further, in October (as of 24th of the month), FTSE/NAREIT All REIT Index return gained pace and came in at 6.13%, compared to 4.31% growth for the S&P 500.

However, over the first nine months of 2013, REITs have underperformed the broad market. Total return of the FTSE NAREIT All REITs Index was up only 2.89% compared to the increase of 19.79% for the S&P 500. Notably, the FTSE NAREIT All Equity REITs Index moved north 3.03% while the FTSE NAREIT Mortgage REITs Index dropped 2.11%.

Though the third-quarter 2013 earnings picture has improved in the most recent week, we notice that the guidance still remains on the weak side, leading to negative estimate revisions at a majority of the companies.

Amid such an environment and along with disappointing government job reports, we hope that the Fed’s QE program will continue for a period more than previously anticipated. This should keep the demand for high-dividend-paying REIT stocks alive.

Dividends Are Key Attraction

The U.S. law requires REITs to distribute 90% of their annual taxable income in the form of dividends to shareholders. Yield-hungry investors thus 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 September 30, 2013, the dividend yield of the FTSE NAREIT All REITs Index was 4.34%. The yield of the FTSE NAREIT All Equity REITs Index was 3.68% while the FTSE NAREIT Mortgage REITs Index delivered a dividend yield of 11.33%. Clearly, the REITs continued to offer solid yields and outpaced the 2.14% dividend yield offered by the S&P 500 as of Sep 30.

Capital Access

Accessibility to capital is a prime factor in the REIT industry. After raising $51.3 billion capital in 2011 and a total of $73.3 billion in 2012, REITs raised $60.6 billion in the first nine months of 2013. A solid IPO market in 2013 primarily made it happen.

In the first three quarters, REITs raised $3.08 billion through 14 IPOs that comfortably surpassed the $1.82 billion capital infusion through 8 IPOs in 2012. The third quarter has been the most active one with around $1.25 billion raised from 4 IPO offerings.

During the latest downturn, REITs were able to acquire premium properties from highly leveraged investors at heavy discounts. Furthermore, REITs typically have a large unencumbered pool of assets, which could provide an additional avenue to raise cash during crisis.

These assets, in turn, have provided the requisite wherewithal to the REIT industry to grow through strategic acquisitions over time. Moreover, the financing for sound properties is currently abundant as willing commercial real estate lenders continue to extend lending.

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.

As a point of reference, the outlook for industries with Zacks Industry Rank #88 and lower is 'Positive,' between #89 and #176 is 'Neutral' and #177 and higher is 'Negative.'

The Zacks Industry Rank for REIT Equity Trust - Other is #81, REIT Equity Trust - Retail is #104, REIT Mortgage Trust is #105 and REIT Equity Trust - Residential is #177. Analyzing the Zacks Industry Rank for different REIT segments, it is obvious that while the outlook for REIT equity trust – other remain at the low end of the positive range, the rest of the industries – mortgage trusts, residential equity trusts and retail equity trusts are in the neutral zone.

Earnings Trends

Currently, we are into the heart of third quarter 2013 earnings season with results from nearly half of the S&P 500 companies already declared.

The broader Finance sector, of which REITs are part, has been less of a growth contributor this quarter. Results by industry behemoths like JPMorgan Chase & Co. (JPM) and The Goldman Sachs Group, Inc. (GS) were not impressive and the growth momentum has slowed over the quarters. But the majority of S&P 500 REITs are yet to report their earnings.

Among the finance companies that have already reported, the ‘earnings beat ratio’ (percentage of companies with positive surprises) was 56.4% while the ‘revenue beat ratio’ was 43.6%. Total earnings for this sector were up 13.0% year over year, moderating from the 36.0% growth in the second quarter. Total revenue moved south 1.0% verses 8.9% growth in the prior quarter.

Looking at the consensus earnings expectations for the rest of the year, we are encouraged by the estimated 12.2% growth for the third quarter and 32.8% for the fourth, implying full-year 2013 growth of 13.3%.

For a detailed look at the earnings outlook for this sector and others, please read our Earnings Trend report.

OPPORTUNITIES

REIT Equity Trust - Other

This is a diversified group of REIT companies and notable segments in it are as follows:

Industrial/Storage REITs: With a larger customer base, rise in e-Commerce application and supply chain consolidation, the demand for logistics infrastructure and efficient distribution networks has grown.

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 CubeSmart (CUBE), Extra Space Storage Inc. (EXR), Public Storage (PSA) and Sovran Self Storage Inc. (SSS) look promising.

Lodging/Resorts REITs: With improving U.S. business and strong international travel and tourism volumes, the lodging sector is expected to remain in the recovery path. Pricing in this industry is anticipated to rise on limited supply and rising demands. Stocks worth a look include Sotherly Hotels Inc. (SOHO), LaSalle Hotel Properties (LHO) and Sunstone Hotel Investors Inc. (SHO).

Healthcare REIT: These REITs are likely to benefit from the projected 7.4% rise in national health expenditures in 2014, 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 2021.

Though the forthcoming wave of retiring baby boomers is often cited as a threat to the U.S. economy, this is a boon for the healthcare sector as senior citizens spend 200% more than the average population. Moreover, the Affordable Care Act would substantially raise new insured individuals thereby raising the demand not just 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.

We foresee Healthcare REITs like HCP Inc. (HCP) and Ventas Inc. (VTR) capitalizing on this trend.

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

REIT Mortgage Trust

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

Amid increasing yields on the U.S. Treasury 10-year note and apprehensions of the Fed’s pulling out its QE program, mREITs stocks tumbled in May. But in September, the ‘no taper’ announcement curtailed growth projections by the Fed and a lackluster employment scenario implied a continued low interest rate environment which would support the mREITs.

We believe this favorable environment will continue in the near term and support stocks like AG Mortgage Investment Trust Inc. (MITT), Apollo Commercial Real Estate Finance Inc. (ARI), CYS Investments, Inc. (CYS - Snapshot Report) and ZAIS Financial Corp. (ZFC). However, we are somewhat skeptical about the long-term prospects of their business.

REIT Equity Trust - Residential

The demographic growth continues to be strong in the young adult age cohort, or those under age 35, who have a higher propensity to rent. In fact, with the lack of stability in the job market and mounting student debt, home ownership in the under-35 age cohort continues to decline.

Moreover, with stringent mortgage underwriting standards amid new banking regulations, renting has emerged as the only viable option for those who cannot avail of mortgage loans.

This makes us positive on stocks like Post Properties Inc. (PPS), American Residential Properties Inc. (ARPI) and BRE Properties Inc. (BRE).

But with a considerable number of projects nearing completion, we expect supply to increase in the near term. This could slow down rent growth as more companies seek occupancy. However, new starts are likely to be pushed back amid rising construction costs and interest expenses.

WEAKNESSES

Continued low interest rate environment amid protracted economic recovery is good news for the REIT sector. But we believe that the current macroeconomic environment is problematic for the following segments.

REIT Equity Trust - Retail

Since the start of the third quarter, the Retail sector suffered substantial negative estimate revision. We predict thwarted tenant sales in the near term due to tepid economic recovery with weak consumer confidence and a soft job market.

Despite this economic uneasiness, we believe retail properties such as strip centers, housing stores selling grocery items, drugs and other necessary stuff for regular use by the local neighborhood, will perform better than the regional malls in the near term.

In fact, during times of economic slump, the grocery-anchored shopping centers have earned the reputation of putting up a consistent performance and therefore we are bullish on stocks like Cedar Realty Trust, Inc. (CDR) and Regency Centers Corporation (REG - Analyst Report) that have exposure to these properties.

Barring these, we would rather avoid other mall-based REITs like Glimcher Realty Trust (GRT - Snapshot Report) and Taubman Centers, Inc. (TCO - Analyst Report) in the near term.

Though improvements have been noticed in some of the office markets of late, we still find the U.S. economy weighed down by sluggish growth with uninspiring employment data and soft demand for office properties. 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

Macroeconomic issues and political drama have created tension in the market. Yet we foresee improved rents and occupancies as the economic recovery gains momentum. In fact, we believe that rising interest rates should not always be seen as a headwind to REIT stocks. Notably, interest rates move north when the economy gains strength and this, in general, drives demand for properties offered by REITs.

Also, we note that during the 40-year period from 1972 to 2012, average annual total returns for REITs were 8.09%, while the average annual market return was 13.72%. In addition, total returns of equity REITs have consistently provided a hedge against inflation. According to the data from Jan 1978 to Mar 2013, total returns of equity REITs have either equaled or exceeded the inflation rate in 67% of high-inflation six-month periods.

Data on average annual total returns from 1972 through 2012 illustrate the benefit of REITs’ steady income returns. While REIT stocks have exhibited clear potential for strong price appreciation, price returns can fluctuate from year to year. In contrast, REITs have yielded a consistent annual income component of 8.09 percent during that period, representing approximately 60 percent of the industry’s average annual total return of approximately 13.72 percent. So an opportunistic investment in REITs should not disappoint over the long run.

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