REIT Industry Review & Stock Picks - June 2013

by Zacks Equity Research

June 27, 2013 |

These are unusual times for the U.S Real Estate Investment Trust (REIT) industry. After a remarkable run in the first four months of the year, the REIT industry has nosedived since May, and the volatility continues.

Prior to the recent uptrend in interest rates, the demand for these high-dividend-paying stocks remained sky high. In 2012, the industry delivered a solid performance with the stocks beating the broader equity market for the 4th straight year.

However, with the increasing yields on the U.S. Treasury 10-year note (2.55% as of Jun 24, 2013, compared with 1.68% at the end of April), investors are turning their focus away from REITs (primarily the mortgage REITs, commonly known as mREITs). Moreover, rising interest rate environment is a growing concern for the REIT stocks as investors are concerned about the negative impact on the book values and financing costs.

In May, on a total return basis, the FTSE NAREIT All REITs Index lost 6.56% and the FTSE NAREIT All Equity REITs Index lost 5.90% compared with the S&P 500 that gained 2.34%.

The June data looks disappointing as of now, since the FTSE NAREIT All REITs Index lost 6.62% and the FTSE NAREIT All Equity REITs Index lost 6.54% (as of Jun 24, 2013) compared with 4.10% loss for the S&P 500.

Dividends Still Remain an Attraction

With the U.S. law requiring REITs to distribute 90% of their annual taxable income in the form of dividends to shareholders, yield-seeking investors continue to prefer these stocks. This has aided the industry to stand out and gain a strong foothold over the past 15-20 years.

As of May 31, the dividend yield of the FTSE NAREIT All REITs Index was 4.19%, and the dividend yield of the FTSE NAREIT All Equity REITs Index was 3.35%.  Moreover, the dividend yield of the FTSE NAREIT Mortgage REITs Index was 12.55% as of that date compared with 2.14% for the S&P 500.

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 $40.5 billion in the first five months of 2013.

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.

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 the 260 plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit: About Zacks Industry Rank

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 - Retail is #82, REIT Equity Trust - Other is #84, REIT Mortgage Trust is #167, while the REIT Equity Trust - Residential is #180. Analyzing the Zacks Industry Rank for different REIT segments, it is obvious that while the outlook for mortgage trusts and residential equity trusts is leaning towards the negative side, retail equity trusts and other equity trusts remain at the low end of the positive side.

Earnings Trends

The broader Finance sector, of which REITs are a part, remains in excellent earnings shape. The first quarter 2013 results for the sector were impressive in terms of both beat ratios (percentage of companies coming out with positive surprises) and growth.

The earnings "beat ratio" was 73.4% while the revenue "beat ratio" was 51.9%. Total earnings for this sector were up 7.7%, slightly moderating from the 10.0% growth in the fourth quarter of 2012. Total revenues moved north 5.5% in the quarter verses 23.1% growth in the prior quarter.

Looking at the consensus earnings expectations for the rest of the year, we remain encouraged since earnings are expected to grow 19.1% in the second quarter, 7.6% in the third quarter and 27.6% in the fourth quarter, thereby registering full-year 2013 growth of 14.0%.

OPPORTUNITIES

Retail REITs: Being a leader, the U.S. retail industry provides adequate growth prospects for these REITs. Despite the rise in online shopping through the Internet, mobile phones and tablets, it is the physical interaction that the millennial generation stills prefers while shopping. Hence, amid the technological advancements, in order to increase their market dominance, the retail industry keeps on reinventing, redesigning and revamping their physical stores.

With retail properties in premium locations, companies like Kimco Realty Corporation (KIM - Analyst Report), The Macerich Company (MAC - Analyst Report) and Acadia Realty Trust
(AKR) remain our primary choiceS.

Healthcare REIT: Relatively immune to the macroeconomic problems, these REITs are expected to benefit from rising national health expenditures that are projected to grow 3.8% in 2013 and 7.4% in 2014, according to Centers for Medicare and Medicaid Services. Also, the federal agency projects average compounded annual growth rate of health expenditures of 6.2% over 2015 through 2021.

Moreover, 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.

Hence, we believe that Healthcare REITs like HCP Inc. (HCP - Analyst Report), Health Care REIT, Inc. (HCN - Analyst Report) and Healthcare Realty Trust Inc. (HR - Snapshot Report) can capitalize on this trend.

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 have risen.

This has lead to a rising need for industrial/storage facilities and the stocks to consider include Extra Space Storage Inc. (EXR - Snapshot Report), DCT Industrial Trust Inc. (DCT) and CubeSmart (CUBE).

Lodging/Resorts REITs: With the improving U.S. business and strong international travel and tourism volumes, the lodging sector is expected to continue with its recovery. Particularly, the North America market is anticipated to significantly benefit with limited supply and rising demands.

Stocks that worth a look include are Sunstone Hotel Investors Inc. (SHO - Snapshot Report), Diamondrock Hospitality Co. (DRH) and Host Hotels & Resorts Inc. (HST - Analyst Report).

Apartment REITs: With the lack of stability in the job market along with mounting student debt, the home ownership in the under-35 age cohort continues to decline. Since renting has emerged as the only viable option for customers who cannot avail mortgage loans or are unwilling to buy a house at present, we expect the apartment sector to remain comparatively steady in the coming quarters.

We favor stocks like Select Income REIT (SIR - Snapshot Report), Apartment Investment & Management Co. (AIV) and Equity Residential (TM).

WEAKNESSES

For the sector as a whole, rising interest rates are a looming concern. High capital costs erode their profit level and hence trigger a fall in the dividend yield that the investors primarily look for while investing in REIT stocks. Considering individual segments, we believe that the current macroeconomic environment remains a menace for the following sectors.

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

Amid the increasing yields on the U.S. Treasury 10-year note and apprehensions that the Fed will soon pull out its QE program, mREITs stocks are continuing to lose their shine. Subsequently, the FTSE NAREIT Mortgage REITs total returns dropped 17.25% from the beginning of the second quarter till Jun 20, 2013.

In the recent past, mREITs like American Capital Agency Corp. (AGNC) and American Capital Mortgage Investment Corp. (MTGE - Snapshot Report) slashed their dividends. The other stocks that we would like to avoid are Hatteras Financial Corp. (HTS - Snapshot Report) and Newcastle Investment Corp. (NCT - Snapshot Report).

Another division which may underperform is the Office REIT. With the U.S. economy still registering sluggish growth, the demand for office properties, particularly in the suburban market still lacks luster. As such, companies like Mack-Cali Realty Corp. (CLI) have started to trim their office properties and diversify into the relatively stable multifamily apartment sector.

Conclusion

The macroeconomic issues and the political situation have been affecting the market, but we believe that with the economic recovery gaining momentum, rents and occupancies would improve further. Moving forward, limited supply of new construction coupled with the growing demand for premium properties bode well for the REITs, in particular for those that have assets in high barriers-to-entry markets.

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