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REIT Industry Outlook - May 2018

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After lackluster performance in the first two months of 2018, the U.S. REIT industry rebounded in March and positive trend continued in April as well. It seems that the mojo is somewhat back in the space, following the so-far steady performance of REITs this earnings season and stepped up merger and acquisition activities.

Specifically, total returns of 3.74% in March and 0.55% in April for the FTSE NAREIT All REIT Index also managed to outpace the broader market, as the S&P 500 slipped 2.54% in March and inched up just 0.38% in April.

Moreover, despite the Federal Reserve recently acknowledging that inflation is nearing its desired level, any fast-paced hike in rates in the upcoming months is most unlikely as the central bank appears committed to a steady-as-you-go plan. And REITs are usually more adept in absorbing a rate hike when it occurs gradually.

Short-term hiccups from rate hikes and movements of treasury yields cannot be entirely ruled out because of REIT’s traditional dependence on debt for their business and consideration as bond substitutes for their high and consistent dividend-paying nature. But this time around, REITs seem to be better poised to brave the rising rate environment.

Over the years, REITs have shored up capital and made concerted efforts to reduce leverage. These have resorted to equity capital rather than brooding too much on debt capital to finance their portfolio and carry on their business. As such, the industry continued to retain a low leverage level as evidenced by the debt ratio of 31.7% of the FTSE Nareit All Equity REITs Index.

Moreover, not only have the REITs reduced their exposure to interest rate hikes, they have also opportunistically used the low-rate environment to make their financials more flexible, which is encouraging down the line for their operational efficiencies. REITs have made borrowings at a fixed rate and extended the average maturity of their debt outstanding to more than six years, thereby locking the low rates for a prolonged period. Further, REIT dividend growth has surpassed inflation (as measured by Consumer Price Index) in 18 of the past 20 years.

Apart from this, investors should consider the individual market dynamics of the underlying asset category. This is because, even though retail real estate landlords are continuing to bear the brunt of online retailing, store closures and retailers’ bankruptcies, the industrial real estate category is firing on all cylinders and immensely benefiting from an ecommerce boom. So not all REITs are equally poised to excel or fall behind.

Along with this, the tax overhaul under the Trump administration is likely to boost consumption levels. But the impetus that each asset category will receive from a growing economy will command more attention. Also, properties with a shorter-leasing period are likely to stand out amid growing rates.

Further, if the rise in construction activity and the lengthy current real estate cycle point at a late stage of the cycle, then one needs to consider vacancy rates, which are either stable or hovering near lows for the majority of asset categories, suggesting that the industry is not overbuilt yet and that supply is in sync with demand.

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.

As of Mar 31, 2018, the dividend yield of the FTSE NAREIT All REITs Index was 4.59%, which handily outpaced the 2.00% 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 4.27% while the FTSE NAREIT Mortgage REITs Index had a dividend yield of 10.47%. Over long periods, REITs have outperformed the broader indexes with respect to dividend yields.

Capital Access

REITs have made concerted efforts to fortify their balance sheets and focus on lowering debt and extending maturities. They have been proactive in the capital market, and raised $92.6 billion of capital in 2017, well ahead of the $69.6 billion generated in the prior year. Further, as of Mar 31, 2018, the industry has raised more than $15 billion. This denotes investors’ growing confidence in this industry. However, going forward, identification of growth scopes is likely to determine the inflow of capital into 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 the 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. While the Zacks Industry Rank is #101 (top 39% of the 250 plus Zacks industries) for REIT Mortgage Trust, it is #159 (bottom 38%) for Other REIT, #178 (bottom 30%) for Residential REIT and #191 (bottom 25%) for Retail REIT.

Earnings Trends

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 is emerging as a decent performer in the first-quarter reporting cycle.

Further, for the finance sector, of which REITs are part, combining the actual results that have come up with estimates for the still-to-come companies, total earnings are expected to be up 24.4% from the same period last year on 6.6% higher revenues.

For more information on earnings for this sector and others, please read Is the Earnings Picture Really That Strong?

REITs Worth Adding

In this mixed environment, sidelining the entire industry would not be prudent. Instead of being bogged down by the rate hike issues, tap the many novelties in the REIT sector. Since individual market dynamics play a critical role in determining the performance of REITs, favorable conditions only pump up chances of further growth. Also, from a valuation standpoint, several of the REIT stocks stand out.

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.

Bethesda, MD-based Pebblebrook Hotel Trust (PEB - Free Report) is a hotel REIT engaged in acquisition and investment of hotel properties mainly in upper upscale, full-service hotels situated in urban markets in major gateway cities. The stock has a Zacks Rank #1 (Strong Buy). It has a long-term growth rate of 5% and the Zacks Consensus Estimate for 2018 has been revised 4.3% upward in a month’s time.

Innovative Industrial Properties, Inc. (IIPR - Free Report) , headquarter in San Diego, CA, is focused on the acquisition, ownership and management of specialized industrial properties leased to experienced, state-licensed operators for medical-use cannabis facilities. It has a Zacks Rank of 1. The stock has seen the Zacks Consensus Estimate for 2018 being revised 4.5% upward in two months’ time.

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

BRT Apartments Corp. (BRT - Free Report) , based in Great Neck, NY, is a REIT engaged in investing directly and through joint ventures, as well as in acquiring existing multifamily properties. It is also to some extent involved in ground up development of multifamily apartments. It has a Zacks Rank of 2 (Buy). Also, the Zacks Consensus Estimate for fiscal year 2018 earnings is projected to surge 26.9% year over year.

New York-based Apollo Commercial Real Estate Finance (ARI - Free Report) is focused on investing in, acquiring and managing senior performing commercial real estate mortgage loans, commercial mortgage-backed securities, commercial real estate corporate debt and loans, and other real estate debt investments. It has a Zacks Rank of 2. The Zacks Consensus Estimate for 2018 is $1.85. The same for 2019 is pegged at $2.06 and has been revised 1.5% upward in a week’s time.

Note: Anything related to earnings presented in this write-up represents funds from operations (FFO) — a widely used metric to gauge the performance of REITs.

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