In the latest FOMC meeting, the benchmark interest rate was hiked by a quarter point and three more rate hikes were flagged for the current year. So obviously, betting on REIT stocks could be risky in 2018.

In fact, this remains the biggest near-term challenge as the use of leverage for REIT business makes the returns from this industry susceptible to interest rate movements. Particularly, a rise in the interest rate affects the present value of future cash flows. Therefore, asset valuation, including bond coupons and stock dividends, experiences a decline. Also, a number of asset categories are experiencing softness in fundamentals, which limits the scope of growing future cash flows from the properties of the corresponding REITs.

And apart from the rising interest-rate environment and an aging real estate cycle, the skinny consensus growth rate forecast for funds from operations (FFO) of REITs this year and the next, compared with that of the S&P 500 constituents, is anticipated to put the industry at a comparative disadvantage to the broader market.

On one hand, there is limited scope of growth for a number of asset categories of REITs. On the other hand, higher corporate earnings and the recent tax overhaul with lower corporate taxes are likely to boost earnings higher and help the broader market to prosper. Amid all this and along with investors’ increased risk appetite, flow of capital into the defensive REIT industry is likely to slow down in 2018 from the lofty levels experienced last year.

Fundamental Weakness

Retail REIT

Retail REITs continued to bear the brunt as mall traffic continues to suffer amid a rapid shift in customers’ shopping preference through the online channel, resulting in an increasing number of retailers jumping on the dot com bandwagon. These have made retailers reconsider their footprint and eventually opt for store closures in recent years while others unable to cope with competition have been filing bankruptcies.

Such an environment has led to tenants demanding substantial lease concessions but mall landlords are finding these unjustified. In addition, when substantial store closures happen in the middle of the lease term, not only are mall landlords hurt, but tenants occupying space in that mall are equally affected because their shop visits depend on the mix of specific types of retailers.

However, retail REITs are fighting back and transforming their traditional retail hubs into entertainment destinations and lifestyle resorts in an attempt to lure customers. In fact, changing consumer preferences and omnichannel retailing are reshaping the retail real estate environment and retail REITs are adopting the latest technologies to offer attractive services to their tenants and mall visitors. Nevertheless, the implementation of such measures requires a decent upfront cost and is hence likely to limit growth in the profit margins of retail REITs in the near term.

Residential REIT

The performance of residential REITs has already been affected over the last few quarters because of elevated supply. Although delays resulting from labor shortage and escalating costs have pushed the peak season, the stressed environment is anticipated to continue in the near term and likely to curb residential landlords’ ability to command more rents and affect concession levels. Further, with some of the residential REITs’ development deliveries running behind schedule amid delays in construction activities, lease-up net operating income may be affected.

Office REIT

Improving economy and a healthy job market environment are expected to drive growth in the office real estate market in 2018. But the pace of such growth is anticipated to be modest with increased supply of office space that has been curbing the pricing power of landlords and resulting in elevated concession levels.

Healthcare REIT

Elevated new supply in the market is anticipated to continue in the upcoming quarters, thereby resulting in persistent softness in seniors housing fundamentals. In addition, healthcare providers are opting for cost containment, less-expensive delivery settings and new technologies. Also, demand for medical office buildings and urgent-care facilities is growing. But amid the implementation healthcare reforms, healthcare REITs have been distancing themselves from the skilled nursing facility (SNF) business.

In fact, while seniors housing, medical-office buildings and hospitals have been able to realize solid revenue growth in recent years, SNFs are becoming more susceptible to top-line pressure due to the gradual shift in the medical billing procedure that stresses more on the value of care provided rather than the volume of services offered.

Rate Hike Issues

Admittedly, rising rates will adversely impact the debt-dependent REITs. However, the pace and magnitude of rate hikes, and the capacity of REITs to absorb those increases will significantly shape the industry’s outlook. So REITs with lower pricing power and longer lease durations have less chances of beating the rate hike blues efficiently.

Also, volatility in rates affect the performance of mortgage REITs, or mREITs, which offer real estate financing through the purchase or origination of mortgages and mortgage-backed securities. These REITs fund their investments with equity and debt capital and earn profits from the spread between interest income on mortgage assets and their funding costs.

Bottom Line

Therefore, prior to calling the shots, investors should satisfy themselves by dispassionately absorbing both sides of the argument.

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

REITs to Avoid

Specific REITs that we don't like are American Assets Trust, Inc. (AAT Quick QuoteAAT - Free Report) , Corporate Office Properties Trust COPT, Seritage Growth Properties (SRG Quick QuoteSRG - Free Report) and Xenia Hotels & Resorts, Inc. (XHR Quick QuoteXHR - Free Report) .

San Diego, CA-based American Assets Trust is a REIT engaged in acquisition, improvement, development and management of retail, office and residential properties throughout the United States. It has a Zacks Rank #5 (Strong Sell). The stock has seen the Zacks Consensus Estimate for 2017 and 2018 being revised southward over the past month.

Corporate Office Properties Trust, headquartered in Columbia, MD, is engaged in ownership, management, leasing, development and selective acquisition of high quality office and data center properties. It has a Zacks Rank of 5. The stock has seen the Zacks Consensus Estimate for 2018 being revised downward in a month’s time, reflecting the bearish sentiment of analysts on this stock.

You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

New York-based Seritage Growth Properties is a retail REIT having wholly-owned properties and joint venture assets aggregating around 40 million square feet of space across 49. It has a Zacks Rank of 5. Notably, the Zacks Consensus Estimates for 2017 and 2018 have experienced downward revisions of 12.4% and 9.1%, respectively, over the past two months.

Xenia Hotels & Resorts, Inc., based in Orlando, FL, is a REIT that makes investments mainly in premium full service and lifestyle hotels. The company targets the top 25 U.S. lodging markets and key leisure destinations in the United States. It has a Zacks Rank of 5. Xenia Hotels & Resorts’ long-term expected growth rate of 5% is below the industry’s 6.2% growth rate. Moreover, the Zacks Consensus Estimates for 2017 and 2018 have experienced downward revisions over the past two months.

Note: All EPS numbers presented in this write up represent funds from operations (“FFO”) per share. FFO, a widely used metric to gauge the performance of REITs, is obtained after adding depreciation and amortization and other non-cash expenses to net income.