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Industry Outlook

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Despite macroeconomic headwinds primarily resulting from the weak jobs market, the U.S. rating downgrade in the summer, the ongoing sovereign debt crisis in Europe, and fears of a double-dip recession in the U.S. until about a few months ago, the Real Estate Investment Trust (REIT) industry outperformed the overall stock market in third quarter 2011, albeit with lesser-than-expected returns. The FTSE NAREIT Equity REIT Index had total returns of -14.7% in third quarter 2011 versus -15.3% and -15.5% for the Russell 3000 Index and the S&P 500 Index, respectively.

A combination of factors has helped the REIT industry to stand out. During the crest-to-trough period of 2007 to 2009, REITs took on far less debt than private real estate investors, and many were able to sell at the top of the market when private equity investors were still buying.

Importantly, during the downturn, REITs were able to acquire properties from highly leveraged investors at deeply discounted prices. This enabled them to add premium high-return assets to their portfolios.

Furthermore, REITs managed to raise capital to pay off debt, owing to a large inflow of funds as institutional investors allocated more "dry powder" to the industry, making them an increasingly attractive investment proposition. For the first nine months of 2011, REITs raised $43.4 billion in equity and was well on course to either match or surpass the $47.5 billion in equity raised in 2010.

According to data from NAREIT, leverage ratio of listed REITs (total debt against market capitalization) as of September 30, 2011 was 38% -- significantly lower than 51% at the end of second quarter 2008 prior to the Lehman Brothers collapse due to the Great Recession.

In addition, REITs typically have a large unencumbered pool of assets, which could provide an additional avenue to raise cash during crises. Consequently, industry experts believe that REITs are comparatively better equipped to continue outperforming the broader market and currently have the wherewithal to withstand another recession in the future.

Investors looking for high dividend yields have historically favored the REIT sector. Solid dividend payouts are arguably the biggest enticement for REIT investors as the U.S. law requires REITs to distribute 90% of their annual taxable income in the form of dividends to shareholders. The dividend yield for the FTSE NAREIT All REIT Index by the end of third quarter 2011 was 5.2% compared to 1.9% for the 10-year U.S. Treasury Note.

The standout performance in the REIT industry (year-to-date as of December 7, 2011) was that of the Self-Storage REITs (a total return of 30.35% as measured by the FTSE NAREIT Equity REIT Index), followed by Regional Malls (17.75%), Residential (9.07%), and Health Care (7.03%). The relatively underperforming sectors were Lodging/Resorts (-16.31%), and Industrial (-6.28%) REITs.

Moving forward, limited supply of new construction coupled with the growing demand for high-quality properties bode well for the earnings prospects of REITs, in particular those that have assets in high barriers-to-entry markets. According to reports, new construction is currently averaging 390 million square feet per year, compared to 1 billion square feet per year in the decade prior to the global financial crisis. As a result, REITs presently are heavily dependent on inorganic growth to fuel their expansion drive.

OPPORTUNITIES

We are bullish on Public Storage (PSA - Analyst Report), the largest owner and operator of storage facilities in the U.S. The company has significantly increased the scale and scope of its operations through the acquisition of Shurgard Storage Centers that had a considerable presence in the European markets. Although Public Storage currently owns a 49% stake in Shurgard, the size and scope of its operations have enabled it to achieve economies of scale, thereby generating high operating margins and managerial efficiencies.

The "Public Storage" brand is the most recognized and established name in the self-storage industry, with a presence in all the major markets across 38 states in the U.S. In addition, the storage facilities of the company have a high visibility and are usually located in densely populated areas that improve the local awareness of the brand. This offers a significant upside potential for the company.

Another stock worth mentioning is Taubman Centers Inc. (TCO - Analyst Report), which owns, develops and operates regional and super-regional shopping centers throughout the U.S. and Asia. Retail shopping centers spanning over 400,000 square feet of gross leaseable area (GLA) are generally referred to as "regional" shopping centers, while those centers having in excess of 800,000 square feet of GLA are generally referred to as "super-regional" shopping centers.

Taubman focuses on dominant retail malls that command the highest average sales productivity in the U.S., measured in terms of mall tenants’ average sales per square foot. On a trailing 12-month basis, mall tenant sales were $615 per square foot during third quarter 2011. In addition, a large number of these shopping centers are strategically located in the most affluent regions of the country, which include Los Angeles, San Francisco, Denver, Detroit, Phoenix, Miami, Dallas, Tampa, Orlando and Washington DC. This, in turn, enables the retailers to target high-end upscale customers and maximize their profitability.

We also remain bullish on Avalonbay Communities, Inc. (AVB - Analyst Report), one of the best-positioned apartment REITs, primarily focused on developing multi-family apartment communities for higher-income clients in high barrier-to-entry regions of the U.S. Avalonbay has Class A assets located in premium markets, such as Washington DC, New York City and San Francisco, where the spread between renting and owning is still high despite home price declines.

As ‘echo boomers’ (the children of baby boomer generation) opt to move out on their own and more renters decide to part ways with families and roommates, the single-family homeownership rate across the U.S. has persistently declined and the demand for multifamily rental apartments has seen a surge. With new supply remaining muted until late 2013 or 2014, we expect the performance of the multifamily sector as a whole and Avalonbay in particular to remain comparatively stable in the coming quarters, as renting has emerged as the only viable option for customers who could not procure mortgage loans or are unwilling to buy a house at present.

In addition, Avalonbay has a reasonably strong balance sheet with moderate near-term debt maturities and adequate liquidity. Consequently, the company can capitalize on potential acquisition opportunities due to distressed selling from owners and developers who cannot refinance their properties that augur well for its top-line growth.

WEAKNESSES

A significant chunk of REITs are raising capital through property level debt and equity offerings. Although both debt and equity financings provide much-needed cash infusions, these could potentially burden already leveraged balance sheets and dilute earnings. Property level debt is also harder to obtain and more expensive, as commercial real estate prices remain under pressure.

We are bearish on Host Hotels & Resorts, Inc. (HST - Analyst Report), the largest lodging REIT and one of the largest owners of luxury and upper-upscale hotels. The majority of Host Hotels’ properties are concentrated in the luxury and upper-upscale segments, which was the weakest performing segments during the economic downturn. While the outlook for these markets has improved, the pace of improvement remains quite uneven and unsteady.

The hotel industry is also cyclical in nature, and is heavily dependent on the overall health of the U.S. economy. Unfavorable macroeconomic conditions in the past has compelled customers to cut back on discretionary spending and prefer lower priced brands over premium ones. Consequently, demand for Host Hotels had reduced comparatively and if the trend reoccurs in future, the bottom line of the company is likely to be affected, reducing its operating margins.

We also remain skeptical about Prologis Inc. (PLD - Analyst Report), the erstwhile AMB Property Corp. that acquires, develops, operates and manages industrial real estate space in North America, Asia and Europe. Although the quarterly results were in line with the company’s expectations and signified a gradual improvement in market fundamentals, macroeconomic issues have contributed to a slower pace of recovery.

The credit crunch has also widened the bid-ask spread between buyers and sellers of commercial real estate, causing deal volumes to fall from pre-recession levels. In addition, market vacancy increases will mitigate Prologis’ ability to push through rental rate increases. This has significantly affected the long-term growth of the company.

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