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Macroeconomic uncertainty in the United States and consequent sloth in trading activity took a toll on the performance of the real estate investment trust (REIT) industry in the first eight months of 2017. In fact, the industry underperformed the broader market, as indicated by the FTSE/NAREIT All REITs Index’s total return of 7.4% over this timeframe versus the S&P 500’s 11.9% gain.

Despite this, a number of REIT categories showed strength and posted stellar returns. Among them are infrastructure REITs that have gained 34.1% through August this year, while data center REITs have posted a total return of 31.8%. Moreover, industrial REITs delivered returns of 19.3%, handily outpacing the broader market. However, retail REITs bore the brunt with the sector incurring a negative return of 11.4%.

Admittedly, interest rates and the movement of Treasury yields have dominated the returns of the REIT industry, at least in the near term. But, the latest trend of returns for the above-mentioned REIT classes suggest that the focus has now shifted to the fundamentals of the individual asset category to which these cater to, rather than interest-rate movements.

Specifically, demand-supply dynamics and the performance of tenants played a key role in shaping up REIT returns. In fact, growth in cloud computing, Internet of Things and big data is not only helping tech companies, but also driving demand for data center REITs.

Moreover, the industrial asset category hogged attention for experiencing high demand, with the economy and job market displaying signs of recovery, ecommerce gaining strength and the manufacturing environment remaining healthy. However, shrinking mall traffic and store closures amid aggressive growth in online sales kept retail REITs on tenterhooks.

Going forward, REITs dependence on debt for their business and consideration as bond substitutes for their high and consistent dividend-paying nature will still make their short-term returns susceptible to the rate hikes and movements of treasury yields to some extent.

Nevertheless, barring short-term hiccups, this special hybrid asset class has proven time and again that rate hikes do not necessarily impact long-term returns from REIT stocks. Rather, in most cases, the returns have rallied and outperformed broader market gains when the rate has eventually moved north.

Of course, asset valuation, including bond coupons and stock dividends experiences a decline as hike in interest rate impact present value of future cash flows. But for REITs, the rise in rates also ushers in scope for increasing future cash flows. This is how REITs emerge as winners even with rate hikes.

This is because any decision to increase rates would reflect growth in the domestic economy, rising inflation and the Fed’s confidence in the recovery. And when the economy expands, there is growth in jobs and consumer spending, which in turn drives demand for real estate, leads to higher occupancy levels and boosts landlords’ power to command higher rents, thereby supporting REIT earnings, cash flow and dividend. So, the fundamentals of the underlying asset category to which REITs cater to and the impetus the asset category will receive from a growing economy commands more attention.

Dividends Stand Tall

The U.S. law requires REITs to distribute 90% of their annual taxable income in the form of dividends to shareholders. This unique feature made the industry stand out and gain a solid footing over the past 15-20 years.

In fact, dividends are by far the biggest enticement to invest in REIT stocks, and income-seeking investors still continue to prefer them. This is because, as of Aug 31, 2017, the dividend yield of the FTSE NAREIT All REITs Index was 4.1%, which handily outpaced the 2% dividend yield offered by the S&P 500.

Among the REIT market components, the FTSE NAREIT All Equity REIT Index enjoyed a dividend yield of 3.8% while the FTSE NAREIT Mortgage REITs Index had a dividend yield of 9.6%. Over long periods, REITs have outperformed the broader indexes with respect to dividend yields.

Capital Access

In recent years, REITs have also managed their balance sheets well and focused on lowering debt and extending maturities. Also, REITs have indeed been proactive in the capital market, with the stock exchange-listed REITs collecting $69.6 billion in capital offerings in 2016.

Moreover, REITs raised $62.8 billion of capital in the first eight months of 2017, well ahead of the $52.3 billion generated in the comparable period prior year. This denotes investors’ growing confidence in the industry.

Zacks Industry Rank

Within the Zacks Industry classification, REITs are broadly grouped in the Finance sector (one of the 16 Zacks sectors) and further sub-divided into four industries at the expanded (aka "X") level: REIT Equity Trust - Retail, REIT Equity Trust - Residential, REIT Equity Trust - Other and REIT Mortgage Trust. The level of sensitivity and exposure to different stages of the economic cycle vary for each industry.

We rank 256 industries in 16 Zacks sectors based on earnings outlook and fundamental strength of the constituent companies in each industry.

We club our industries into two groups: the top half (industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank). Over the last 10 years, using a one-week rebalance, the top half beat the bottom half by a factor of more than 2 to 1. (To learn more visit: About Zacks Industry Rank.)

However, the industry ranking is not encouraging for the majority of the REIT industry. In fact, the Zacks Industry Rank is #190 (bottom 26% of the 250 plus Zacks industries) for Retail REIT, #178 (bottom 30%) for Residential REIT, #175 (bottom 32%) for Other REIT and #157 (bottom 39%) for Mortgage REIT.

Earnings Trends

Nevertheless, no discussion is complete until we weigh the performance of REITs in earnings and despite wide skepticism of investors toward this industry, it emerged as a decent performer in the recently concluded reporting cycle.

In fact, per a NAREIT media release, occupancy rates remained high in the second quarter, while funds from operations (FFO), a widely used metric to gauge the performance of REITs, reported growth.

Specifically, the second-quarter scorecard revealed that the total FFO of the listed U.S Equity REIT industry of $15.6 billion in the reported quarter increased 7.9% sequentially. The figure also came in 7.3% higher than the prior-year quarter tally.

Same-store net operating income (NOI) grew 3.3% year over year. Results were driven by segments like Single Family Homes, Data Centers and Manufactured Home Communities, which witnessed robust same-store NOI growth of 6.8%, 5.8% and 5.7%, respectively.

Furthermore, properties owned by the listed Equity REITs enjoyed solid occupancy levels. In fact, the occupancy rate remained unchanged at 93.4%, slightly below the record-high occupancy rate of 93.7% in the third and fourth quarters of 2016.

Further, the finance sector, of which REITs are part, is expected to grow in 2017. Total Q3 earnings for the S&P 500 index members from this sector are expected to be up +2.5% from the same period last year on +1.9% higher revenues.

For more information on earnings for this sector and others, please read Q3 Earnings Season Gets Underway.

REITs Worth Adding

In this mixed environment, sidelining the entire industry would not be prudent. Rather, there are chances of scooping up big gains from this special hybrid asset class which benefits from the favorable dynamics of the individual asset categories. So, investors need to remain cautiously optimistic, assess the fundamentals of the underlying asset category as well as the capacity of REITs to absorb a rate hike. Hence, things like lease durations and pricing power in the market would command attention.

Over the last six months, the industry has gained around 2.8% compared with the S&P 500’s return of 5.3%. As the industry underperformed the broader market, the stocks are good bargains now.

Investors can consider the following REIT stocks that have solid fundamentals to weather any rate hike. Also, their favorable Zacks Rank makes them solid picks.

Jericho, NY-based Getty Realty Corp. (GTY - Free Report) is a REIT engaged in the ownership, leasing and financing of convenience store and gasoline station properties in the United States. The stock has a Zacks Rank #1 (Strong Buy). Getty Realty has exceeded estimates in three out of the trailing four quarters with an average beat of 9.8%. The stock has seen the Zacks Consensus Estimate for current-year revised 3.1% upward in a month’s time.

Preferred Apartment Communities, Inc. (APTS - Free Report) , based in Atlanta, GA, acquires and operates multifamily properties primarily in the United States. The stock has a Zacks Rank #2 (Buy) and a VGM Score of A. Preferred Apartment Communities has been a steady performer, having beaten the Zacks Consensus Estimate in three out of trailing four quarters, with an average beat of 6.9%. Its long-term expected growth rate is currently pegged at 7%, ahead of the industry average of 6.3%. You can see the complete list of today’s Zacks #1 Rank stocks here.

InfraREIT, Inc. (HIFR - Free Report) , based in Dallas, TX, enjoys ownership of transmission & distribution properties with long lives, low operating risks and stable cash flows. It has Zacks Rank #2 and its expected long-term growth rate currently stands at 8%.

TIER REIT, Inc. (TIER - Free Report) is a Dallas, TX-based REIT that focuses on ownership of premium, well-managed commercial office properties in dynamic markets throughout the United States. For the past few quarters, TIER REIT has been displaying strength, exceeding the Zacks Consensus Estimate in each of the trailing four quarters, with an average beat of 9.6%. Also, the stock has seen the Zacks Consensus Estimate for current-year being revised 2.6% upward in two months’ time.

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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