The REIT industry has been struggling for the past year, with a combination of macroeconomic uncertainty, the Fed’s tightening cycle and a consequent slowdown in trading activity taking a toll on the performance of stocks. Also, there was skepticism over the plausible impact of the tax overhaul on the REIT industry.
The industry underperformed the broader market, as indicated by the FTSE NAREIT All REIT Index’s total return of around 9.3% over this time frame versus the S&P 500’s 21.8% gain. Nevertheless, the performance was close to the long-term average of 9.7% per year over the 46-year tenure of the Nareit index.
But what caught our attention is the underlying strength in some asset categories like data centers, cell tower and industrial. These categories not only posted stellar returns in 2017 but also have sufficient scope to grow going forward. This is because technological evolution is changing the dynamics of the real estate market and hugely benefiting these sectors.
Take the example of the e-commerce boom that has hugely affected mall traffic and compelled retailers to reconsider their business model in recent times. That same boom has led to a significant opportunity for the data centers, cell tower and industrial REITs that offer the critical infrastructure in the e-commerce value chain. This is because as demand is placed from smartphones, tablets or computers, the order is transmitted through cell towers and processed at data centers. Finally, the order is fulfilled through the industrial/logistics facilities and delivered to the doorstep.
However, interest rates continue to affect the share price of REITs in the near term, and the December FOMC meeting indicates three more rate hikes this year.
Admittedly, REITs’ dependence on debt for their business and consideration as bond substitutes for their high and consistent dividend-paying nature still make their short-term returns susceptible to the rate hikes and movements of treasury yields, to some extent. Particularly asset valuation, including bond coupons and stock dividends, experiences a decline as a hike in interest rate impacts the present value of future cash flows.
But for REITs, there is scope for increasing future cash flows along with the recent rise in rates. This is because, in the December meeting, along with increasing rates, the Fed has also offered a better outlook in terms of GDP growth for 2018, a positive revision in projected inflation and expectations of a “strong” job market. And when the economy gathers steam, REIT business usually buoys up.
But not all categories of REITs are equally poised to excel. Therefore, 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.
And along with all this, the cut in the tax rate on REIT dividends from 39.6% to 29.6% for taxpayers in the top tax bracket, as well as a number of favorable provisions under the recent tax reform, are likely to bring back investors’ attention.
Dividends Stand Tall
Dividends are by far the biggest enticement to invest in REIT stocks, and income-seeking investors still prefer them. This is because the U.S. law requires REITs to distribute 90% of their annual taxable income in the form of dividends to their shareholders. This unique feature has made the industry stand out and gain a solid footing over the past 15-20 years.
In fact, as of Dec 31, 2017, the dividend yield of the FTSE NAREIT All REITs Index was 4.27%, which handily outpaced the 1.86% 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 3.94% while the FTSE NAREIT Mortgage REITs Index had a dividend yield of 9.83%. Over long periods, REITs have outperformed the broader indexes with respect to dividend yields.
REITs have made concerted efforts to fortify their balance sheets and focus on lowering debt and extending maturities. In fact, REITs have been proactive in the capital market, and raised $92.1 billion of capital in 2017, well ahead of the $69.6 billion generated in the prior year. This denotes investors’ growing confidence in this industry. However, going forward, identification of growth scopes is likely to determine the inflow of capital in this 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 #234 (bottom 9% of the 250 plus Zacks industries) for Retail REIT, #200 (bottom 22%) for Other REIT, #183 (bottom 29%) for Mortgage REIT and #174 (bottom 32%) for Residential REIT.
Nevertheless, no discussion is complete until we weigh the performance of REITs in earnings. However, despite wide skepticism of investors toward this industry, the REIT industry emerged as a decent performer in third quarter 2017.
In fact, per a NAREIT media release, occupancy rates reached a record high in the third quarter, while funds from operations (“FFO”), a widely used metric to gauge the performance of REITs, reported growth from the year-ago period. Specifically, the third-quarter scorecard reveals that total FFO of $14.8 billion for the listed U.S. Equity REIT industry increased 7.8% year over year. However, the figure was 4.5% lower sequentially.
Same-store net operating income (NOI) increased 3.2% year over year. Results were driven by segments like Manufactured Homes, Diversified, Single Family Homes, Industrial, and Data Centers, which witnessed robust same-store NOI growth of 7.1%, 7.0%, 6.8%, 4.7% and 4.2%, respectively.
Importantly, properties owned by the listed Equity REITs enjoyed solid occupancy levels. In fact, the occupancy rate climbed 50 basis points to a record high of 94.0%.
Further, the finance sector, of which REITs are part, is expected to grow in 2017. Total Q4 earnings for the S&P 500 index members from this sector are expected to be up 3.1% from the same period last year on 2.4% higher revenues.
For more information on earnings for this sector and others, please read Q4 Bank Earnings Will be Messy & Noisy.
REITs Worth Adding
In this mixed environment, sidelining the entire industry would not be prudent. Rather, instead of being bogged down by the current rate hike news, tap the many novelties in the REIT sector. Since individual market dynamics play a critical role in determining performance of REITs, favorable conditions only pump up chances of further growth.
Over the last six months, the industry has gained around 4.6%, compared with the S&P 500’s return of 13.3%. 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.
BRT Apartments Corp. (BRT - Free Report) , based in Great Neck, NY, is a REIT engaged in investing directly and through joint ventures, acquiring existing multifamily properties, and to some extent ground up development of multifamily apartments. It has a Zacks Rank #1 (Strong Buy). Also, the stock has seen the Zacks Consensus Estimate for fiscal year 2018 being revised 11.8% upward in a month’s time.
Boston, MA-based American Tower Corp. (AMT - Free Report) is an independent owner, operator and developer of multitenant communications real estate. Its portfolio comprises around 149,000 communications sites, including around 40,000 towers in the United States and more than 108,000 towers internationally. The stock has a Zacks Rank of 2 (Buy).
American Tower is a steady performer, having beaten the Zacks Consensus Estimate in each of the trailing four quarters with an average beat of 3.9%. Currently, its expected long-term growth rate is 13%. You can see the complete list of today’s Zacks #1 Rank stocks here.
Terreno Realty Corp. (TRNO - Free Report) , based in San Francisco, CA, is an industrial REIT, engaged in acquisition, ownership and operation of industrial real estate in six major coastal U.S. markets — Los Angeles, Northern New Jersey/New York City, San Francisco Bay Area, Seattle, Miami, and Washington, D.C. The stock has a Zacks Rank of 2. Presently, its long-term expected growth rate is 10%, ahead of the industry average of 6.2%.
Newton, MA-based Select Income REIT (SIR - Free Report) is engaged in ownership of strategic, single tenant office and industrial properties throughout the United States. It has Zacks Rank of 2. The stock has seen the Zacks Consensus Estimate for 2018 being revised 1.8% 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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