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The use of leverage for real estate investment trust (REIT) businesses makes the returns from this industry susceptible to interest rate movements. This is because 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.

In addition to this, weakness in the fundamentals of certain asset categories has added to the woes because it further restricts the scope of enhancing the future cash flows from the properties of the corresponding REITs. Specifically, 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 REITs in the coming months.

Therefore, prior to making any investment in this special hybrid class, one needs to pay close attention to all the weakness.

Fundamental Weakness

Retail REIT

Particularly, 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 times. In fact, the decision to close stores by a number of reputable retailers like Macy's, Inc. (M - Free Report) , J. C. Penney Company, Inc. (JCP - Free Report) and Sears Holdings Corporation , have raised concerns over cash flows of mall landlords.

Further, retailers unable to cope with competition have been filing bankruptcies. This is a pressing concern for retail REITs, as the trend has been considerably curtailing demand for the retail real estate space.

This choppy retail real estate market situation is also said to have led to tenants demanding substantial lease concessions, which mall landlords are finding unjustified. Moreover, significant store closures in the middle of the lease term not only hurt mall landlords, but also the tenants occupying space in that mall because their shop visits also depend on the mix of specific types of retailers.

Amid these, retail REITs are fighting back and giving their malls a facelift in an attempt to lure customers. They are also adopting the latest technologies to offer attractive services to their tenants and mall visitors as well as transforming their traditional retail hubs into 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.

Residential REIT

Growth in supply in a number of property types is hurting fundamentals. Specifically, after achieving excellent growth over the past few years, residential REITs now have an excess of new apartment deliveries in several markets.

In fact, for the overall U.S. apartment market, fourth-quarter 2017 is projected to be the peak period for deliveries. However, delays resulting from labor shortage and escalating costs could push the peak season to first-quarter 2018, as the expected completion dates of a number of projects are changing to early 2018 from late 2017.

Per the apartment pipeline data from Axiometrics, a RealPage Inc. (RP) company, in 2018, the Washington, DC and Los Angeles markets are likely to witness an upswing in construction, while new units in New York and Seattle markets are expected to hover near the 2017 levels.

Elevated supply has already affected the performance of residential REITs over the last few quarters. The anticipation of a stressed environment in the near term is also likely to curb their 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 is expected to be affected.

Self-Storage REIT

In the self-storage industry, there is softness in demand, with customers remaining under stress due to the current economic environment. Additionally, supply has been rising in a number of markets and this is hurting the storage REITs’ pricing power and revenue growth.

Healthcare REIT

Softness in seniors housing fundamentals is also likely to continue in the upcoming quarters amid a rise in new supply in the market. This is anticipated to restrict healthcare REITs’ pricing power and occupancy level.

Moreover, with 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 growing.

But amid the implementation healthcare reforms, the corresponding REITs have been distancing themselves from the skilled nursing facility (SNF) business. This is because though 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.

In fact, tenants of SNFs derive the majority of their revenues in the form of payments from Medicare and other government insurance programs. However, these tenants have been facing shorter stays and lower rates amid the shift in the billing practices, which stresses more on the value of care provided rather than the volume of services offered.

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. In fact, a lot of new buildings are slated to be completed and made available this year and next, leading to higher supply and lesser scope for rent and occupancy growth.

Rising Rates Pose a Threat

Finally, rising rates will have an impact 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, with rates moving north, healthcare REITs are generally at risk because these usually have significant exposure to long-term leased assets, which carry fixed rental rates that are subject to annual bumps. As a result, when the rate goes up, the cost of borrowing will increase, while their revenue flows will not get adjusted quickly for their fixed-rate nature, leading to an adverse impact on profitability.

Moreover, performance of mortgage REITs, or mREITs, which offer real estate financing through the purchase or origination of mortgages and mortgage-backed securities, are affected by the volatility in rates. 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.

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 are NexPoint Residential Trust, Inc. (NXRT - Free Report) , Retail Opportunity Investments Corp. (ROIC - Free Report) , CorEnergy Infrastructure Trust, Inc. (CORR - Free Report) and Public Storage (PSA - Free Report) .

Dallas, TX-based NexPoint Residential Trust, Inc. is an externally advised, publicly traded, REIT. The company focuses on acquisition, asset management, and disposition of multifamily properties, situated mainly in the Southeast United States and Texas. It has a Zacks Rank #5 (Strong Sell). The stock has seen the Zacks Consensus Estimate for current-year being revised southward over the past 60 days.

Retail Opportunity Investments Corp., based in San Diego, CA, is a retail REIT that focuses on the acquisition, ownership and management of grocery-anchored shopping centers situated in densely-populated, metropolitan markets across the West Coast. It has a Zacks Rank #4 (Sell). The company came up with a lower-than-expected performance last quarter. Also, the Zacks Consensus Estimate for 2017 has experienced downward revisions over the past two months.

Kansas City, MO-based CorEnergy Infrastructure Trust, Inc. is a REIT engaged in ownership of essential energy assets, like pipelines, storage terminals, and transmission and distribution assets. Presently, it has a Zacks Rank #4. Over the past 60 days, the Zacks Consensus Estimates for current-year have been revised southward, reflecting the bearish sentiment of analysts on this stock.

Public Storage, based in Glendale, CA, is a REIT that primarily acquires, develops, owns and operates self-storage facilities. It has a Zacks Rank #4. The company does not have an impressive surprise history. In fact, over the trailing four quarters, the company missed the Zacks Consensus Estimate in two periods, resulting in an average miss of 3.18%. Also, the Zacks Consensus Estimate for 2017 experienced downward revisions over the past two months.

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

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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