Even though the benchmark interest rate was kept unchanged in the latest FOMC meeting, the acknowledgement by Fed officials of continued expansion of economic activity, a strong job market environment and inflation nearing the target level indicates that a number of rate hikes are on course this year and in the next.
Amid this, short-term hiccups from rate hikes and movements of treasury yields are likely to prevail for REITs because of their traditional dependence on debt for business and consideration as bond substitutes for high and consistent dividend-paying nature.
Moreover, apart from rate hike issues, individual market dynamics of the underlying asset category plays a pivotal role in determining the performance of REITs. Therefore, if an improving economy, job market gains, corporate profits and tax cuts are spurring demand for a number of asset categories, rising supply, evolving trade policies and several such issues are softening fundamentals and limiting the scope of growing future cash flows from the properties of related REITs.
Therefore, the performance of the REIT Equity Trust – Other industry, which is basically a diversified group comprising REIT stocks from different asset categories like industrial, office, lodging, healthcare, self-storage, data centers and others, is guided by several factors.
For example, industrial REITs are gaining traction as high consumer spending, strengthening e-commerce market, and a healthy manufacturing environment amid a recovering economy and job market are spurring demand for this real estate category. However, any protectionist trade policies will have an adverse impact on economic growth, as well as this asset category’s business over the long term. Also, a whole lot of new buildings are slated to be completed and made available in the market in the near term, leading to lesser scope for rent and occupancy growth.
For the lodging/resort REITs, fundamentals are expected to be favorable in the near-to-mid term amid economic recovery. Particularly, business travel is likely to benefit from rising corporate profits and corporate tax cuts, as well as a healthy business investment, while leisure travel is expected to gain from low unemployment level and rising wages. Nevertheless, though supply growth was tepid in the past, it has gathered momentum in recent times and is expected to remain elevated in 2018 and 2019, thereby affecting pricing power.
Also, favorable demographic changes, improving job market and rising income, are fueling demand for space in the self-storage industry, but growth might be checked due to the development boom in many markets. In case of office REITs, although an improved economy, a healthy job market environment and growing corporate profit are raising expectations, there is a slowdown in gross asking rent growth, with a demand-and-supply balance.
For data center REITs, growth in cloud computing, Internet of Things and big data, and an increasing number of companies opting for third-party IT infrastructure are providing impetus for growth. However, aggressive pricing pressure and substantial debt burden are likely to limit that growth tempo.
Healthcare REITs are benefiting from the aging baby boomer population. Specifically, cost containment, less expensive delivery settings and new technologies are driving the demand for medical office buildings, outpatient facilities as well as urgent-care facilities.
However, lately there are areas of concern. 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. Also, healthcare REITs are more sensitive to rising interest rates than other asset classes, thanks to their long-term leases.
Industry Lags in Terms of Shareholder Returns
Looking at shareholder returns year to date, it appears that the broader economic recovery wasn’t enough for enhancing investors’ confidence in the industry’s growth prospects. Elevated supply, aggressive pricing pressure, government policy changes and rate hike issues have affected the performance of REIT – Others industry over the past quarters.
The REIT and Equity Trust - Other Industry, which is a group within the broader Zacks Finance Sector, has underperformed the S&P 500 but outperformed its own sector, year to date. While the stocks in this industry have collectively lost 0.8%, narrower than the 2.6% decline of the Zacks Finance Sector, the Zacks S&P 500 Composite has rallied 6.5%.
Year-To-Date Price Performance
However, it’s worth noting that there was a significant lack of synchronization in the performance of individual asset categories within the group. While REITs from industrial, lodging/resorts, self-storage registered decent gains, the same from office and diversified REITs remained subdued and affected the group’s returns.
Valuation Looks Reasonable
For REITs, price-to-FFO (funds from operations) multiple is a common measure for valuation. This is because FFO is a widely used metric to gauge the performance of REITs rather than net income, as it indicates cash flow from their operations.
FFO is obtained after adding depreciation and amortization to earnings and subtracting the gains on sales. This is done because although per GAAP accounting norms, REITs are required to depreciate their investment properties over time, in reality many properties experience value appreciation over time.
So, to offset that impact, depreciation and amortization are added back. Moreover, gains on sales of property are subtracted since such sales are considered nonrecurring in nature.
Despite the underperformance of the industry year to date, the valuation does not look cheap when compared to its median level of the range over this period. The industry currently has a trailing 12-month P/FFO of 16.18 and the median level is 15.71. However, considering the highest level of 16.21 year to date, there is some upside left.
On the other hand, the space also looks inexpensive when compared with the market at large as the trailing 12-month P/E ratio for the S&P 500 is 19.67 and the median level is 19.57.
Industry May Perform Better on Improving FFO per Share Outlook
Despite supply issues, evolving government policies and rate hike possibilities, prospects of a number of this special hybrid asset class are getting a boost with growth in economy, job market gains, high consumer confidence and tax cuts, which are translating into greater demand for real estate and resulting in higher occupancy levels.
But what really matters to investors is whether this group has the potential to perform better than the broader market in the quarters ahead. In fact, 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 its FFO per share outlook. FFO per share revisions trend for the constituent companies usually influences their stock market performance.
The Price & Consensus chart for the industry shows the market's evolving bottom-up FFO per share expectations and the industry's aggregate stock market performance. The red line in the chart represents the Zacks measure of consensus FFO per share expectations for 2019, while the light blue line represents the same for 2018.
Price and Consensus: Zacks REIT-Equity Trust – Other industry
This becomes even clearer if we focus on the aggregate bottom-up FFO per share revisions trend. The chart below shows the evolution of aggregate consensus expectations for 2018.
Please note that the $2.50 FFO per share estimate for the industry for 2018 is not the actual bottom-up dollar FFO per share estimate for every company in the REIT - Equity Trust - Other industry, but rather an illustrative aggregate created by our proprietary analytics model. The key factor to keep in mind is not the FFO per share of the industry for 2018, but how this value has evolved recently.
Current Fiscal Year FFO Per Share Estimate Revisions
As you can see here, the $2.50 FFO per share estimate for 2018 is marginally up from $2.49 at the end of July and $2.47 at the end of the month prior to that, but down from $2.55 this time last year. Looking at the aggregate FFO per share estimate revisions, it appears that although analysts became pessimistic about this group’s FFO per share potential earlier, they are now gaining confidence about the same.
Zacks Industry Rank Indicates Cloudy Prospects
However, the group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates continued underperformance in the near term.
The Zacks REIT and Equity Trust – Other industry currently carries a Zacks Industry Rank #164, which places it at the bottom 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.
Revenue Trend of REIT - Other Shows Some Promise
While the near-term prospects look unwelcoming for investors, the uptrend in revenues over the past years appears promising. This might support long-term growth in FFO per share.
Keeping the long-term expectations in mind, investors could take advantage of the cheap valuation compared with the market and bet on a few REIT - Other stocks that have a strong FFO per share outlook.
Moreover, REITs have extended the average maturity of their debt to longer terms, locking in previous low interest rates. This is encouraging down the line for their operational efficiencies as well as for investors because interest expense is expected to take a smaller bite out of REITs’ earnings. Consequently dividend yields and profitability for investors are expected to improve.
Here are the stocks that one can consider:
Outfront Media Inc. (OUT - Free Report) : The stock of this New York-based REIT, which provides out-of-home advertising space like billboard, transit and digital displays in key markets throughout the United States and Canada, has lost 4.2% of its value over the past three months. However, the stock now seems a good buying opportunity backed by its bright prospects.
The Zacks Consensus Estimate for the 2019 FFO per share has been revised 4% upward over the last 30 days. It has a Zacks Rank #1 (Strong Buy). (You can see the complete list of today’s Zacks #1 Rank stocks here.)
Price and Consensus: OUT
Park Hotels & Resorts Inc. (PK - Free Report) : The consensus FFO per share estimate for this Tysons, VA-based lodging REIT has moved north 2.1% and 4.1%, respectively, for 2018 and 2019, over the last 30 days. The stock has appreciated 4.5% over the past three months. It has a Zacks Rank of 2 (Buy).
Price and Consensus: PK
PS Business Parks, Inc. (PSB - Free Report) : The stock of this Glendale, CA- REIT, which is engaged in the acquisition, development, ownership and operation of commercial properties, primarily multi-tenant industrial, flex and office space, has gained 12.5% over the past three months. The consensus FFO per share estimate for the current year has been revised 0.3% upward over the last 30 days. It has a Zacks Rank of 2.
Price and Consensus: PSB
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