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REIT and Equity Trust Outlook: Fed Worries Are Overblown

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REIT and Equity Trust industry, which consists of mortgage real estate investment trusts (mREITs), has been on a tear since 2016 (the FTSE NAREIT Mortgage REIT index logged in a gain of 22.85%). Notably, returns for longer holding periods reflect moderation but are still impressive 12.4% (annualized) over the past three years, and 9.3% over a five-year horizon.  

However, with the number of projected interest-rate hike in 2018 increasing to four, the near-term growth prospects for the mREITs are being questioned, as the business model makes it difficult for the companies to perform in a rising-interest environment.

Simply put, since these REITs borrow at short-term interest rates to fund purchases of mortgages and mortgage-backed securities (MBS), even small increments in borrowing costs can result in tightening of the net interest margin (NIM) — spread between interest income on mortgages and funding costs.

However, it seems that tensions about rising interest rates are overblown. While rising rates could pressurize NIM and eventually hurt dividend yields, the regular source of income from mortgage payments should go a long way in offsetting share-price decline for mREITs.

Also, with the most recent interest-rate hike, the Fed indicated that the economy is growing at a ‘solid’ pace. Hence, economic strength and healthy consumer sentiment will likely mitigate the impact of higher interest rates, benefiting this segment.

Industry Lags on Shareholder Returns

Looking at shareholder returns over the past year, it appears that the broader economic recovery was inadequate for boosting investors’ confidence in the industry’s growth prospects. A confluence of circumstances — rising U.S. Treasury yields and higher mortgage delinquencies — can be blamed for the industry’s lackluster performance.

The Zacks Zacks REIT and Equity Trust industry, which is within the broader Zacks Finance Sector, has underperformed both the S&P 500 and its own sector over the past year.

While the stocks in this industry have collectively lost 2.1%, the Zacks S&P 500 Composite and Zacks Finance Sector have rallied 13.8% and 4.5%, respectively.

One-Year Price Performance



mREITs Stocks Trading Cheap

Thanks to the underperformance of the industry over the past year, the valuation looks really cheap now. One might get a good sense of the industry’s relative valuation by looking at its price-to-book ratio (P/BV), which is probably the most appropriate multiple for valuing mREITs considering the fact that their assets and liabilities represent fair value of securities held. Meaning, the book value of such companies might actually be representative of their market value.  

This ratio essentially measures an mREIT’s current market value relative to what it would be worth if all assets were sold, debt was paid.

The industry currently has a trailing 12-month P/BV ratio of 1.18, near the median level of one-year range. When compared with the highest level of 1.26, over that period, there is apparently plenty of upside left.

The space also looks inexpensive when compared with the market at large, as the trailing 12-month P/BV ratio for the S&P 500 is 3.99 and the median level is 3.77.

Price-to-Book Ratio (TTM)


 

As finance stocks typically have a lower P/BV ratio, comparing mREITs with the S&P 500 may not make sense to many investors. But a comparison of the group’s P/BV ratio with that of its broader sector ensures that the group is trading at a decent discount. The Zacks Finance Sector’s trailing 12-month P/BV ratio of 2.58 and the median level of 2.56 for the same period are way above the Zacks REIT and Equity Trust Industry’s respective ratios.

Price-to-Book Ratio (TTM)



Industry May Outperform on Improving Earnings Outlook

Although anticipations of further rate hikes remain a concern for investors, there is still scope for improvement in the NIM. This metric should be considered the holy grail of metrics for investors to follow when analyzing mortgage REITs, as these companies now consider adjustable-rate mortgages instead of fixed-rate mortgages for reliable future revenues.

But what really matters to investors is whether this group has the potential to perform better than the broader market in the quarters ahead. While the above ratio analysis shows that there is a solid value-oriented path ahead, one should not really consider the current price levels as good entry points unless there are convincing reasons to predict a rebound in the near term.

One reliable measure that can help investors understand the industry’s prospects for a solid price performance going forward is the industry's earnings outlook. Empirical research shows that earnings outlook for the industry, a reflection of the earnings revisions trend for the constituent companies, has a direct bearing on its stock market performance.

The Price & Consensus chart for the industry shows the market's evolving bottom-up earnings expectations for the industry and the industry's aggregate stock market performance. The red line in the chart represents the Zacks measure of consensus earnings expectations for 2019, while the light blue line represents the same for 2018.

Price and Consensus: Zacks REIT and Equity Trust Industry



This becomes even clearer by focusing on the aggregate bottom-up EPS revisions trend. The chart below shows the evolution of aggregate consensus expectations for 2018.

Please note that the $1.57 'EPS' estimate for the industry for 2018 is not the actual bottom-up dollar EPS estimate for every company in the Zacks REIT and Equity Trust industry, but rather an illustrative aggregate number created by our proprietary analytics model. The key factor to keep in mind is not the dollar earnings of $1.57 'per share' of the industry for 2018, but how this dollar number has evolved recently.

Current Fiscal Year EPS Estimate Revisions




As you can see here, the $1.57 'EPS' estimate for 2018 is up from $1.55 at the end of April and $1.56 at the end of the June. In other words, the sell-side analysts covering the companies in the Zacks REIT and Equity Trust industry have been steadily raising their estimates.
 
Zacks Industry Rank Indicates Prospects for Improvement

The group’s Zacks Industry Rank is basically the average of the Zacks Rank of all the member stocks.

The Zacks REIT and Equity Trust industry currently carries a Zacks Industry Rank #91, which places it at the top 36% of more than 250 Zacks industries. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

REIT and Equity Trust Industry Display Dismal Long-Term Prospects

The long-term prospects for the industry are discouraging. When compared with the broader Zacks S&P 500 composite, the long-term (3-5 years) EPS growth estimate for the Zacks REIT and Equity Trust industry does not appear promising. The group’s mean estimate of long-term EPS growth rate has declined sharply from the high of 4.96 achieved in January 2018 to reach the current level of 3%. It also compares unfavorably with 9.8% growth for the Zacks S&P 500 composite.

Mean Estimate of Long-Term EPS Growth Rate



Nonetheless, the recovering top-line performance that the Zacks REIT and Equity Trust industry has shown since 2015 is encouraging.



Bottom Line

While short-term hiccups from rate hikes and movements of treasury yields cannot be entirely ruled out due to heavy dependence of mREIT on short-term debt, companies that lend at variable interest rates or have efficiently hedged interest-rate risk may have fewer reasons to worry.

Furthermore, companies in the sector have understood that diversification is the name of the game and hence, are reshuffling their portfolio with an optimum mix of agency-guaranteed mortgages, as well as the non-agency ones. Also, industry players are making efficient use of hedging tools, such as interest-rate swaps and duration matching, to provide adequate protection.

Moreover, REITs have extended the average maturity of their debt to longer terms, locking in previous low interest rates. Hence, interest expense is expected to take a smaller bite out of REITs’ earnings, consequently improving dividend yields and profitability for investors.  

In fact, keeping the long-term expectations in mind, investors could take advantage of the cheap valuation and bet on a few mREIT stocks that have a strong earnings outlook.

We have only one stock from the REIT and Equity Trust industry sporting a Zacks Rank #1 (Strong Buy), while there are other two that have been witnessing positive earnings estimate revisions and carry a Zacks Rank #2 (Buy).

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

Sutherland Asset Management Corp. SLD: The consensus EPS estimate for this New York-based company has moved 1.2% higher for the current year over the last 60 days. The Zacks Rank #1 stock has climbed 13% over the past year.

Price and Consensus: SLD




New Residential Investment Corp. (NRZ - Free Report) has been seeing positive revisions in earnings estimates for the last 60 days. Analysts have revised estimates 1.4% upward for the current year. Further, this Zacks #2 Ranked stock has jumped 15.7% in a year’s time.

Price and Consensus: NRZ




Ladder Capital Corp. (LADR - Free Report) is also witnessing a surge in current-year earnings estimates, with the consensus mark being revised 2.4% north in 60 days’ time. The Zacks Rank #2 stock has rallied 21.8% in the past year.

Price and Consensus: LADR



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