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Why Betting on REITs Could Be Risky Now

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Even though the benchmark interest rate was kept unchanged in the latest FOMC meeting, the acknowledgement by Fed officials that inflation is nearing the target level indicates that a number of rate hikes are on course this year and next.

Admittedly, for REITs, this remains the biggest near-term challenge as the use of leverage for REIT business makes the returns from this industry susceptible to interest rate movements. Moreover, the dividend payout itself might become less attractive than the yields on fixed income and money market accounts. Particularly, a rise in the interest rate affects the present value of future cash flows. Therefore, asset valuation, including bond coupons and stock dividends, is expected to experience a decline.

Apart from this, the softening of fundamentals in a number of asset categories indicates limited scope of growing future cash flows from the properties of the corresponding REITs. Also, REITs with lower pricing power and longer lease durations have less chances of beating the rate hike blues.

Let’s now delve more into the headwinds for the following REIT segments.

Retail REIT

Retail REITs are not in the pink as mall traffic continues to suffer from the rapid shift in customers' shopping preference through the online channel. In fact, with ecommerce gaining market share from the traditional brick-and-mortar stores, retailers are compelled to reconsider their footprint and eventually opt for store closures in recent years while others unable to cope with competition have been filing bankruptcies.

Specifically, the first few months of 2018 witnessed several preeminent retail bankruptcy filings and record-high defaults by retail corporates. Moreover, recent data from real estate research firm Reis which Reuters had cited, reveals that U.S. retail real estate vacancies persisted at the 10% levels for first-quarter 2018.

Such an environment has also led to tenants demanding substantial lease concessions but mall landlords are finding these unjustified. In addition, when substantial store closures happen in the middle of the lease term, not only are mall landlords hurt, but tenants occupying space in that mall are equally affected because their shop visits depend on the mix of specific types of retailers.

However, retail REITs are fighting back and transforming their traditional retail hubs into entertainment destinations and lifestyle resorts in an attempt to lure customers. But, in the process, vacancies are escalating in Class B- and below properties. Moreover, with huge outlay for refurbishments, growth in the profit margins of retail REITs in the near term is likely to be curbed.

Residential REIT

The latest report from the real estate technology and analytics firm RealPage, Inc. (RP) reveal that the national apartment market indeed moderated in first-quarter 2018. Going by statistics, the annual rent growth shrunk to 2.3% in Q1. This not only marked moderation from the 2.6-2.9% growth rate experienced throughout 2017 but also denoted the slowest growth since third-quarter 2010.

Of course, the first quarter marks a slow leasing period, thanks to the cold weather that inhibits shift of households and limits growth in demand. However, a whole lot of new supply is the ultimate culprit, fueling competition and curbing landlords’ pricing power.

Also, occupancy level of 94.5% this March edged down from the prior-year tally of 95%, with metros having subdued construction activity faring well and recording the strongest occupancy. Although the overall occupancy level is still healthy, the deceleration suggests that a competitive leasing environment is fast building up, and any robust upturn in occupancy seems elusive in the near term.

This is quite obvious when so much of new supply is likely to come on course. According to the RealPage report, during the last half of 2017, across the nation’s 150 largest metros “annual pace of completions” climbed above the 300,000-unit level. Further, through early 2019, “scheduled new supply” will keep adding on to the flow at about the same annual pace.

Therefore, the stressed environment is anticipated to continue in the near term and likely to curb residential landlords' ability to command more rents and affect concession levels.

Office REIT

If improved economy, healthy job market environment and growing corporate profit raise expectations of robust fundamentals for the office market, then investors should perhaps think twice. This is because supply of office space has been rapidly increasing. In fact, according to data from CBRE Group, in Q1, new supply aggregated 12.3 million square feet, which was marginally lower than the two highest quarterly aggregates of this cycle.

Amid high supply, the overall vacancy rate climbed 20 basis points to 13.3% in the quarter while rent growth decelerated from the recent peak levels. The average gross asking rent inched up 0.7% sequentially and 1.4% year over year. The situation is particularly worsening in the downtown markets where annual rent growth has just managed to grow 0.2%. Therefore, the pricing power of landlords remains curbed and elevated concession levels rule the market.

Healthcare REIT

Healthcare REITs are more sensitive to rising interest rates than other asset classes, thanks to their long-term leases. Moreover, despite the sector benefiting strongly from the aging baby boomer population, there are areas of concern of late. Particularly, there is softness in seniors housing fundamentals as supply has escalated rapidly in recent times in this asset category.

Moreover, skilled nursing facilities are becoming more susceptible to top-line pressure due to the gradual shift in the medical billing procedure that stresses more on the value of care provided rather than the volume of services offered.

mREITs

Also, volatility in rates affect the performance of mortgage REITs, or mREITs, which offer real estate financing through the purchase or origination of mortgages and mortgage-backed securities. 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. Therefore, these REITs face increased spread volatility when rates climb up.

REITs to Avoid

Specific REITs that we don't like are DDR Corp. DDR, Seritage Growth Properties , New Senior Investment Group Inc. and Mack-Cali Realty Corp. (CLI - Free Report) .

Beachwood, OH-based DDR Corp. is a retail REIT engaged in the ownership and management of value-oriented shopping centers across the United States. It has a Zacks Rank # 5 (Strong Sell). The stock has seen the Zacks Consensus Estimate for 2018 and 2019 being revised 2.1% and 5.2% southward over the past month.

New York-based Seritage Growth Properties is a retail REIT having 253 retail properties, aggregating more than 40 million square feet, in 49 states and Puerto Rico. It has a Zacks Rank of 5. Notably, the Zacks Consensus Estimates for 2018 and 2019 have experienced downward revisions of 16.7% and 4.0%, respectively, over the past three months.

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

New York-based New Senior Investment Group Inc. is a real estate investment trust focused on investing in senior housing properties across the United States. It has a Zacks Rank of 5. The stock has seen the Zacks Consensus Estimate for 2018 and 2019 being revised 8% and 7.4% downward, respectively in two months’ time.

Jersey City, NJ-based real estate investment trust (REIT) Mack-Cali Realty Corporation is engaged in ownership, management and development of office and multifamily properties in select waterfront and transit-oriented markets throughout the Northeast. It has a Zacks Rank of 4 (Sell). The stock has seen the Zacks Consensus Estimate for 2018 and 2019 being revised 9.8% and 8.6% downward, respectively in two months’ time, reflecting the bearish sentiment of analysts on this stock.

Bottom Line

Therefore, prior to 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.

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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