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Why Betting on REITs Could Be Risky Now

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The possibility of several rate hikes over the next two years have already hit headlines and curtailed REIT investors’ gains. What has added to the woes is the weakness in the fundamentals of certain asset categories. Particularly, changes in consumer preferences and supply issues in a number of asset classes have affected the market fundamentals and are likely to continue thwarting growth of corresponding REITs in the coming months. Therefore, unless close attention is paid to all the weaknesses before investing in REIT stocks, one might end up incurring huge losses.

Fundamental Weakness

Particularly, there has been a rapid shift in customers’ shopping preferences and patterns, with online purchases growing by leaps and bounds. Amid this, mall traffic continues to suffer. This has forced retailers to reconsider their strategy and shift investments from traditional retailing to online channels and optimize their brick-and-mortar presence.

While it is quite normal for retailers to do so, these optimization efforts and the consequent decision to close stores by a number of reputable retailers like Macy’s Inc. (M - Free Report) , Sears Holdings Corp. and JC Penney (JCP - Free Report) in recent months, have raised concerns over cash flows of mall landlords. Also, retailers that are not able to cope with competition are filing bankruptcies. This is resulting in higher vacancies in existing malls.

However, retail REITs are fighting back and giving their malls a facelift in a desperate attempt to lure customers. They are also adapting the latest technologies to offer attractive services to their tenants and mall visitors as well as transforming their traditional retail hubs into swanky entertainment destinations. However, the implementation of such measures requires a decent upfront cost and, hence, is likely to limit growth in the profit margins of retail REITs in the near term.

On the other hand, growth in supply in a number of property types is hurting the fundamentals. Specifically, after achieving phenomenal growth over the past few years, residential REITs are thumped with new apartment deliveries in several markets. This has upset market fundamentals and curtailed landlords’ ability to demand higher rents and increase the occupancy level. Particularly, class A apartments have been the worst affected.

In fact, per the apartment market data from AXIOMetrics, national rent-growth rate of 2.2% in April 2017 marked a 181-bps decline from the 4.0% of April 2016. Also, national occupancy rate of 94.8% in April was 33 bps lower than the 95.2% recorded in April 2016. The rate has however been steady since December 2016. Also, with increased occupancies, apartment operators are forced to offer rent discounts to lure tenants.

Furthermore, there seems to be no respite from the situation anytime soon and the moderation is anticipated to continue this year with a lot of new construction slated to be delivered.

In the self-storage industry, rising supply in some of the markets is affecting revenue growth. On the other hand, though the U.S. industrial real estate market is enjoying a considerable boost in demand because of the exponential growth of the e-commerce business, supply has started to gain substantial momentum to put an end to the lengthiest stretch of demand supply imbalance in the market that started way back in 2010. Also, a whole lot of new buildings are slated to be completed and made available this year and in the next, leading to higher supply and lesser scope for rent and occupancy growth.

For hotel REITs, though supply growth was tepid in the past, it has gathered momentum in recent times. In fact, lodging fundamentals are anticipated to take a beating in 2017, with supply growth expected to accelerate in 2017, particularly in key markets. Also, business travel has yet to reach optimum levels. Moreover, European travel continues to be weak as a result of a strong U.S. dollar and residual effects from the impact of Brexit.

Rising Rates Pose a Major Threat

Rising rates will no doubt be a burden on the debt-dependent REITs. Particularly, the pace and magnitude of rate hikes, and the capacity of REITs to absorb those increases are expected to substantially shape the industry’s outlook. Therefore, things like lease durations and pricing power in the market would command much attention.

Specifically, health care REITs are generally at risk with rates moving north. This is because these REITs usually have significant exposure to long-term leased assets which carry fixed rental rates that are subject to annual bumps. Therefore, as the rate goes up, the cost of borrowing will increase but their revenue flows will not get adjusted quickly for their fixed-rate nature, leading to an adverse impact on profitability.

Further, volatility in rates can cast a pall on 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. Though these types of REITs have started adjusting their strategies and business models, they bear long-term risk as interest rates will eventually rise.

Apart from these, the dividend payout itself might turn out less attractive than the yields on fixed income and money market accounts in the event of a rate hike.

Bottom Line

Before 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 include Spirit Realty Capital, Inc. (SRC - Free Report) , CorEnergy Infrastructure Trust, Inc. (CORR - Free Report) , New Senior Investment Group Inc. (SNR - Free Report) and FelCor Lodging Trust Incorporated FCH.

Spirit Realty Capital is a REIT which acquires single tenant, operationally essential real estate where the tenants conduct retail, service or distribution activities. It has a Zacks Rank #5 (Strong Sell). Its full-year 2017 estimates have experienced southward revision over the past 30 days.

CorEnergy Infrastructure is a REIT, which is engaged in ownership of essential energy assets, like pipelines, storage terminals, and transmission and distribution assets. Presently, it has a Zacks Rank #4 (Sell). Its estimates for 2017 have experienced downward revision over the past 30 days, 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 Senior Investment Group Inc. is a REIT focused on investing in senior housing properties across the United States. Presently, it has a Zacks Rank #4 (Sell). The company came up with a lower-than-expected performance in the prior quarter. Also, its estimates for 2017 have experienced downward revisions over the past three months.

FelCor Lodging Trust is REIT with a geographically diverse portfolio of high-quality hotels in key urban and resort markets. It has a Zacks Rank #4. The company does not have a decent surprise history. In fact, over the trailing four quarters, the company missed the Zacks Consensus Estimate in two periods, with an average miss of 4.39%.

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.

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