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Forget a Rate Hike, Here Are Reasons to Be Optimistic on REITs

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Despite the looming Fed tightening and bond market pullback, there are enough reasons to be cautiously optimistic on REITs. Prominent among these are the industry’s inherent fundamental strength and sufficient scope to excel under the Trump presidency.

In fact, fiscal stimulus like tax reduction and infrastructure spending drive demand, fuel economic growth and push up inflation and amid all this, the fundamentals of the real estate industry also get a boost. But as not all asset categories are equally capable of thriving, it would be apt to find out those real estate areas that have favorable supply-demand dynamics and the opportunity to prosper. Further, the creation of the exclusive headline sector for real estate under the GICS raised expectations of drawing in billions and pushing up valuations over time.

So if investors can manage short-term hiccups in treasury yields and digest the rate hike issue, the strengthening of the REIT industry will likely ensure solid long-term gains. Also, these hiccups can offer you solid entry points.

Industrial REIT

In the industrial real estate market, demand for space has been high for several quarters. Per a study by the commercial real estate services’ firm CBRE Group Inc. , for the U.S. industrial market, availability fell for 26 straight quarters to 8.2% in fourth-quarter 2016.

Amid economic expansion, e-commerce boom and heightened urbanization, companies are shifting their strategy toward services like same-day delivery and other such options, propelling demand for warehouse distribution facilities. And with a larger customer base, they are opting for supply-chain consolidation, resulting in greater demand for logistics infrastructure and efficient distribution networks, thereby creating scope for industrial REITs to flourish. And with supply remaining considerably tight, growth in rent has been strong in most of the industrial markets in the nation in recent quarters.

Moreover, construction of mega industrial houses spanning 1 million square feet or more is rampant in large industrial markets, according to another report from CBRE Group. Around 90 million square feet of these mega facilities, which benefit from growing e-commerce business, have been accomplished since 2010 in the top 10 markets, while an additional 31.6 million square feet is under construction, with 60% pre-commitments, reflecting solid demand for such facilities.

Against such a favorable backdrop, the industrial sector has climbed great heights, logged in an impressive total return of 30.72% and emerged as the top performing Equity REIT market segment for the year.

Data Center REITs

Growth in cloud computing, Internet of Things and big data is not only helping tech companies, it is also driving demand for data center REITs. In fact, these REITs pulled in their capital and scored well on the return book, registering total returns of 26.41% in 2016.

Office REIT

Office REITs are experiencing decent demand in recent times. In fact, the overall office vacancy rate declined 10 basis points (bps) to 12.9% in fourth-quarter 2016, denoting the lowest level since first-quarter 2008. Also, in 2016, gross asking rent growth touched 6.0%, which denoted the fastest annual rate since 2007. Going forward, with economic improvement and recovery in the job market, demand for office space is expected to shoot higher.

Residential REIT

In apartment markets, supply has been a major concern in recent months, particularly in the high end and luxury apartment categories. However, market fundamentals are still steady in the mid-range markets. So companies having a portfolio that is diversified both in terms of geography and price points have the scope to enjoy relatively stable revenues.

On the other hand, the student housing market recorded solid rent growth in the fall 2016 leasing session, though leasing slowed to some extent, per a recent study by Axiometrics. Going by statistics, the effective rent levels for fall 2016 averaged $618 per bed nationally. This denotes a rise of 2.3% from the year-ago period, with the majority of properties averaging in the range of 2–4%.

Moreover, with a higher education earnings gap – millennials with high school diplomaare earning just 62% of what college graduates are making – college enrollment is set to increase and this would drive up demand of residential units that student REITs lease. Also, there is pent-up demand for new, purpose-built student housing properties that have better amenities than old, outdated housing.

Further, student housing REITs have decent opportunities to excel in the coming years as demand is emanating for on-campus developments from universities that are facing state budget cuts and low funds, and are incapable of developing or renovating their ageing housing properties. And on-campus housing usually enjoy full occupancy.

Retail REIT

For retail REITs, issues like decline in mall traffic and store closures amid the online sales boom will dominate the market going ahead. However, the way mall REITs like GGP Inc. and Simon Property Group Inc. (SPG - Free Report) came forward to acquire Aeropostale and save the apparel retailer from bankruptcy has set an example in the market. This could in fact be a way retail landlord address their tenants’ business troubles in the future.

Moreover, upbeat consumer confidence and increasing consumer spending amid an improving economy infuse optimism in the retail market. Further, amid rising competition from online retailers, retail REITs are focusing on the omni-channel retailing concept, transforming their boring shopping hubs into swanky entertainment zones and distribution centers as well as embracing the latest technologies to offer attractive services to tenants and mall visitors. Eventually, such measures are likely to help in increasing traffic.

Retail REITs also prefer expansion of small shops, which comprise service-based industries such as saloons and spas, personal fitness, and medical practices. Such properties enjoy frequent customer traffic, are Internet-resistant, and therefore drive a dependable traffic.

Also, mixed-use developments have gained popularity for their solid neighborhood character, greater housing variety and density. Such developments lower the distance between housing, workplaces, retail businesses, and other amenities and destinations. Hence, such development enable the companies to grab the attention of people, who prefer to live, work and play in the same area – a trend that drove development in several other cities in the U.S.

Therefore to explore these positives of mixed-use developments, REITs like AvalonBay Communities Inc. (AVB - Free Report) and Regency Centers Corporation (REG - Free Report) went for the Market Common Clarendon. Also, Mack-Cali Realty Corp. is focused on transforming itself through waterfront and transit-based office holdings, and on luxury multi-family portfolio growth, which is encouraging.

Stocks to Add to Your Portfolio

Specific REITs that we prefer include EPR Properties (EPR - Free Report) , The GEO Group, Inc. (GEO - Free Report) , Urban Edge Properties (UE - Free Report) and Piedmont Office Realty Trust, Inc. (PDM - Free Report) .

EPR Properties is specialty REIT that invests in three primary segments: Entertainment, Recreation and Education. EPR has a long-term growth rate of 8.3%, ahead of the industry average of 5.5%. It has a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

The GEO Group, Inc. is a REIT that specializes in the design, development, financing and operation of correctional, detention and community reentry facilities. It is a steady performer, having surpassed the Zacks Consensus Estimate in the trailing four quarters, with an average surprise of 13.3%. It has a Zacks Rank #2. Also, its estimates for 2017 are moving north over the past three months.

Urban Edge Properties acquires, develops, owns, manages and improves shopping centers in urban communities. For Urban Edge Properties, the projected growth rate is 38.7% for 2016 and 5.4% for 2017.

Piedmont Office Realty Trust is engaged in the ownership, management, development, and operation of high-quality, Class A office properties situated in select sub-markets of major U.S. cities. It has a Zacks Rank #2 and its estimates for 2017 have moved north over the past two months.

Check out our latest REIT Industry Outlook here for more on the current state of affairs in this market from an earnings perspective.

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