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Near-Term Outlook for Equity REIT Stocks Appears Bleak

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The Zacks REIT and Equity Trust - Other industry is a diversified group, containing REIT stocks from diverse asset classes such as industrial, office, lodging, healthcare, self-storage, data centers and others. These REITs rent spaces in the properties to tenants, earning a rental income in return.

The Federal Reserve’s dovish stance with respect to rate hikes amid sluggish inflation came as a relief for REITs, as traditionally this asset class has been dependent on debt for conducting business. However, individual market dynamics of the underlying asset category play a key role in determining REITs’ performance. Therefore, if a healthy economy, job-market gains and high consumption levels are infusing optimism for elevated demand of a number of asset classes; 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.

So here we go through the major themes in the industry:

Healthy U.S. Economy and Favorable Demographic Growth: A healthy U.S. economy, job-market gains and high consumption levels are translating into elevated demand for real estate, leading to higher occupancy levels and landlords’ greater power to ask for higher rents. Particularly, with a decent economy and stability in the job market, healthy growth in demand for office spaces will likely continue.

Along with a sound economy, growth in the millennial generation is redefining retail trends and leading to an e-retail boom, thereby opening up scope for Industrial REITs’ growth. Boomers have also been embracing technology, adding to such favorable trends. Also, the aged population or the “silver tsunami” is shaping up healthcare REITs’ fate, since this group constitutes the largest customer base of healthcare services, which spends more on healthcare services than the average population, spurring demand for seniors housing assets, skilled nursing facilities and others.

Technological Wave: Technological evolution has been changing the dynamics of the real estate market and substantially driving demand at a number of asset categories. The e-commerce boom, in particular, has significantly fueled demand for logistics facilities, besides helping cell towers and data centers. Companies are making efforts to improve supply-chain efficiencies, propelling demand for logistics infrastructure and efficient distribution networks.

Additionally, with growth in cloud computing, Internet of Things and big data, and an increasing number of companies opting for third-party IT infrastructure; data-center REITs are experiencing a boom market. Data-analytics expertise of self-storage REITs are offering a competitive advantage and driving their performance.

Elevated Deliveries of New Units and Trade Policies: Nevertheless, despite a healthy economy and robust job growth, rising delivery of new units in several asset categories, such as industrial, office, senior housing and self-storage, has kept REITs on tenterhooks. Rising construction acitivities with increased completions is moderating landlords' ability to command more rents and grow occupancy levels, and resulting in high concessions as well. Therefore, slowdown in leasing velocity and compression in rent growth are likely near-term concerns.

In the self-storage industry, growth might be limited due to the development boom in many markets, while healthcare REITs continue to witness softness in seniors housing fundamentals as supply has shot up rapidly, lately, in this asset category. In addition, any protectionist trade policies will have an adverse impact on economic growth, and affect the business of industrial REITs over the long run. For data-center REITs, aggressive pricing pressure and substantial debt burden might limit growth tempo.

Zacks Industry Rank Indicates Bleak Prospects

The Zacks REIT and Equity Trust - Other industry is housed within the broader Zacks Finance sector. It carries a Zacks Industry Rank #154, which places it at the bottom 40% of more than 250 Zacks industries.

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates bleak near-term prospects. 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.

The industry’s positioning in the bottom 50% of the Zacks-ranked industries is a result of negative funds from operations (FFO) per share outlook for the constituent companies in aggregate. Looking at the aggregate FFO per share estimate revisions, it appears that analysts are losing confidence in this group’s growth potential. Over the past year, the industry’s FFO per share estimate for 2019 and 2020 moved down 1.6% and 0.4%, respectively.

Before we present a few stocks that you may want to consider for your portfolio, let’s take a look at the industry’s recent stock-market performance and valuation picture.

Industry Leads on Stock Market Performance

The REIT and Equity Trust - Other Industry has outperformed the broader Zacks Finance sector, as well as the Zacks S&P 500 composite in a year’s time.

The industry has rallied 15.1% during this period compared to the S&P 500’s rise of 2.6%. During the same time frame, the broader Finance sector has declined 4.6%.

One Year Price Performance

Industry’s Current Valuation

On the basis of forward 12-month price-to-FFO (funds from operations) ratio, which is a commonly used multiple for valuing REIT - Others, we see that the industry is currently trading at 16.98X compared to the S&P 500’s forward 12-month price-to-earnings (P/E) of 16.45X. The industry is trading above the Finance sector’s forward 12-month P/E of 12.74X. This is shown in the chart below.

Forward 12 Month Price-to-FFO (P/FFO) Ratio

Over the last five years, the industry has traded as high as 18.94X, as low as 14.20X, with a median of 16.07X.

Bottom Line

In a nutshell, despite job-market growth, favorable demographics, technological developments and lifestyle transformations, the delivery boom in certain asset classes in the near- to mid-term may strain rental rates and result in high concessions. Nonetheless, REITs have improved their leverage level over the years. And despite the overall industry having a disappointing outlook, REITs catering to certain asset categories have scope to excel. Therefore, we present three stocks from the industry with a favorable Zacks Rank that investors may consider adding to their portfolios.

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

Headquartered in Boca Raton, FL, The GEO Group, Inc. (GEO - Free Report) is an equity REIT that specializes in the design, development, financing and operation of correctional, detention and community reentry facilities. It has operations in the United States, Australia, South Africa and the U.K. The GEO Group delivered an average positive surprise of 29.39 % in terms of FFO per share, over the past four quarters. Moreover, this Zacks Rank #1 stock has seen the Zacks Consensus Estimate for 2019 FFO per share being revised 18.7% north in a month’s time.

San Francisco, CA-based Prologis, Inc. (PLD - Free Report) is a leading industrial REIT that acquires, develops, operates and manages industrial properties in the United States and across the globe. This Zacks #2 (Buy) Ranked stock generated an average positive surprise of 1.02% in terms of FFO per share, over the trailing four quarters. Reflecting positive sentiments, the stock’s Zacks Consensus Estimate for the current-year FFO per share moved 1.6% north to $3.22 in the past month.

Glendale, CA-based PS Business Parks Inc. (PSB - Free Report) is into ownership, acquisition, development and operation of commercial real estate properties, especially multi-tenant industrial, flex and office space. The company is poised to excel as the industrial real estate market is witnessing improving fundamentals amid growth of e-commerce business and supply-chain strategy transformations. It carries a Zacks Rank of 2, at present. Also, PS Business Parks’ Zacks Consensus Estimate for the ongoing year’s FFO per share inched up 0.2% to $6.59 in two months’ time.

Note: Funds from operations (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.

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