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Why Building a Position in REIT Stocks Makes Sense

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The REIT industry’s performance has long being ruled by movements in interest rates, particularly treasury yields. But with fundamentals of the underlying assets playing as important a role in determining REITs’ price performance, demand-supply dynamics and tenant performance are commanding attention.

In fact, a number of asset categories are displaying strength with the economy and the job market showing signs of recovery. The REITs catering to these are generating solid returns, at times even above the broader market.

Moreover, the growing importance of the REIT industry over the years is quite evident and the creation of the exclusive headline sector for real estate under the Global Industry Classification Standard (GICS) last year raised expectations of drawing in billions and pushing up valuations over time.

Also, the U.S. REIT market has continued to expand with the FTSE NAREIT All REITs Index, comprising 227 REITs with a combined equity market capitalization of $1.126 trillion at the end of August 2017. This is ahead of 219 REITs and $972 billion in equity market capitalization at the end of April 2016.

Further, investors' faith in this sector and their willingness to pour money into it is increasing. This is apparent when we look at the industry’s capacity to raise capital from the market. In fact, in the first eight months of 2017, REITs raised $62.8 billion of capital that was well ahead of the $52.3 billion generated in the comparable period prior year.

Therefore, the time is now apt to explore the industry in depth and scoop up big gains.

Data Center REITs

Growth in cloud computing, Internet of Things and big data, and an increasing number of companies opting for third-party IT infrastructure are driving demand for data center REITs. In fact, demand is outpacing supply in top-tier data center markets and despite enjoying high occupancy, these markets are absorbing new construction at a faster pace.

Additionally, according to a Cisco forecast, global “data center-to-data center” IP traffic is expected to witness a compound annual growth rate of 32% over the 2015-2020 period. Further, per Gartner reports, worldwide IT spending growth is projected to increase 3.3%, while worldwide server shipments are expected to rise 4.0% in 2017. This, along with improved outlook for economic growth, is anticipated to drive demand for data centers. In fact, this REIT segment pulled in capital and scored well on the return book through August 2017, registering total returns of 31.8%.

Industrial REIT

In the industrial real estate market, demand for space has been high for several quarters. Going by numbers, per a study by the commercial real estate services’ firm – CBRE Group Inc. CBG – the overall U.S. industrial real estate market remained upbeat in the second quarter, with the industrial availability rate declining 10 basis points to 7.8%.

This marked not only the market’s 27th decline in the past 28 quarters, but also the lowest level since first-quarter 2001. Obviously, a recovering economy and job market gains aided this improvement, but the e-commerce boom and a healthy manufacturing environment were the chief drivers. Also, lower-than-expected completion of construction kept supply numbers at check.

Particularly, amid economic expansion, e-commerce development and heightened urbanization, companies are shifting their strategy toward services like same-day delivery and other options, propelling demand for warehouse distribution facilities. Also, according to a report from Prologis Inc. (PLD - Free Report) , for a given level of revenues, online retailers require three times the distribution center space compared with traditional retailers. This is creating scope for industrial REITs like Prologis, DCT Industrial Trust Inc. DCT and Liberty Property Trust (LPT - Free Report) to prosper.

Office REITs

In addition, the U.S. office vacancy rate remained steady at 13% in the second quarter amid balanced demand-supply, according to a report from CBRE Group. In around half of the U.S. office markets, vacancy recorded a decline and the national office vacancy rate is hovering close to its post-recession low.

Additionally, corporate profits are up and business confidence has recovered. Going forward, with economic improvement and recovery in the job market, demand for office space is expected to shoot up.

Residential REITs

Further, defying concerns about supply in the market, the residential real estate market is back with a bang driven by robust demand. Per a study by the real estate technology and analytics firm, RealPage, Inc. (RP - Free Report) , the second-quarter demand level of 175,645 apartments across the nation marked one-third increase from the level witnessed a year ago. This helped occupancy to remain high at 95.0% as of mid-year and led to stabilization in the annual pace of rent growth, which came in at 3.6%, close to 3.7% growth experienced in the first quarter.

Notably, job formation and checked move-outs for buying homes acted as catalysts. Also, construction labor shortages have somewhat helped the industry to witness comparatively lesser supply through the first eight months of the year than anticipated earlier.

Moreover, with a higher education earnings gap – millennials with a high school diploma are earning just 62% of what college graduates are making – college enrollment is set to increase and this would drive demand for residential units that student housing 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 aging housing properties. And on-campus housing usually enjoys full occupancy.

Healthcare REITs

In the healthcare asset category too, with the aging population and healthcare providers opting for cost containment, less expensive delivery settings and new technologies, demand for medical office buildings as well as urgent-care facilities is on the rise.

Per a CBRE Group report, for the past seven years absorption of medical office space has surpassed new supply. This helped the segment’s national vacancy rate to fall to 8% as of first quarter 2017. Also, high demand for this asset category has led to an increase in transaction volume in the segment that touched around $10 billion for the year ending first-quarter 2017, per the report.

In addition, university-based life science real estate is a new zone of investment, which has grabbed attention and health care REITs are making decent investments in this segment. Such investments help to capitalize on growing health-care-driven research and development, supported by top-tier research universities.

Increasing longevity of the aging U.S. population, along with biopharma drug development growth opportunities, have promoted institutional life science and medical-market fundamentals. Further, long-lease terms and top-rated, institutional quality tenants assure steady growth in cash flows for health care landlords.

Retail REIT

Admittedly, shrinking mall traffic and store closures amid aggressive growth in online sales have kept retail REITs on tenterhooks. In addition, tenants are demanding substantial lease concessions owing to a choppy retail market scenario. Nonetheless, retail REITs are countering this dreary situation and putting in every effort to boost productivity of malls, by trying to grab attention from new and productive tenants and disposing the non-productive ones.

Amid the ongoing changes in consumer behavior, retail REITs are avoiding heavy dependence on apparel and accessories and transforming their boring shopping hubs into swanky entertainment zones. They are expanding dining options, opening up movie theaters and offering recreational facilities. Eventually, such measures are likely to push up traffic.

Retail REITs also prefer expansion of 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 dependable traffic.

Mixed-Use Developments

Mixed-use developments too 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 developments enable 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.

To explore these positives of mixed-use developments, both residential REITs like AvalonBay Communities Inc. (AVB - Free Report) and retail REITs like Regency Centers Corp. (REG - Free Report) and Federal Realty Investment Trust (FRT - Free Report) have directed their investments toward such projects in recent years.

Stocks to Add to Your Portfolio

Specific REITs that we prefer include UMH Properties, Inc. (UMH - Free Report) , Seritage Growth Properties , Xenia Hotels & Resorts, Inc. (XHR - Free Report) and AGNC Investment Corp. (AGNC - Free Report) .

UMH Properties, Inc. is a Freehold, NJ-based REIT that is into ownership and operation of manufactured home communities. The properties are situated in New Jersey, New York, Ohio, Pennsylvania, Tennessee, Indiana, Michigan and Maryland. UMH Properties has a long-term expected growth rate of 10% compared with the industry average of 6.3%. It has a Zacks Rank #2 (Buy).

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 more than 40 million square feet of space across 49 states and Puerto Rico. It has a Zacks Rank #2. Also, the stock has seen the Zacks Consensus Estimate for current-year being revised upward over the past 60 days.

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 #2. Xenia Hotels & Resorts has been a steady performer, having beaten the Zacks Consensus Estimate in three out of trailing four quarters, with an average beat of around 8%. Its long-term expected growth rate is currently pegged at 5%.

Bethesda, MD-based AGNC Investment Corp. is an internally managed real estate investment trust. It invests in agency mortgage-backed securities on a leveraged basis, financed primarily through collateralized borrowings structured as repurchase agreements. It has a Zacks Rank #2 and has exceeded the Zacks Consensus Estimate in each of the trailing four quarters with an average beat of 11.7%.

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

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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