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Industry Outlook

Zacks Equity Research

REIT Industry Stock Outlook - June 2016

UDR ESS AVB

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The year 2016 has so far favored the U.S. Real Estate Investment Trust (REIT) industry. In fact, despite the rate hike last December, the first one since 2006, the REIT industry managed to outpace the broader market in the first five months of the current year, thanks to positive fundamentals of the underlying asset categories and cheap capital inflow.

For the year through May 31, the total returns of the FTSE/NAREIT All REITs Index were 6.5% against the 3.6% increase logged by the S&P 500 Index. This outperformance suggests that investors are getting increasingly comfortable with the rate issues and expect the hike to be modest.

Further, the June hike seems to be off the table with the latest disappointing jobs data and productivity falling to a negative. The icing on the cake was the recent speech by Fed Chief Janet Yellen, who despite sounding upbeat about U.S. economic growthand cautioning investors against overreacting to lone data, failed to give any hint on the timing of the next rate hike. U.S. Treasury yields too have been declining in recent times.

Amid all these upheavals in the economy, the decline in Treasury yields and an anticipated extension of the low rate period, the REIT industry remains a good choice, especially for income-seeking investors, for its steady and dependable cash flows. And because of their high dividend paying nature, REITs are treated as bonds. So REIT stock yields tend to become more attractive when Treasury yields fall.

Also, demand-supply dynamics in the individual asset categories and their impact on occupancy levels and pricing power of the real estate landlords play a pivotal role in selecting REIT stocks.

This is because, even in this favorable rate environment, residential REIT stocks have plummeted on concerns of abundant supply in the New York and San Francisco markets. Equity Residential, which blamed new rental apartment supply for hurting rent growth, cut the 2016 guidance for same store revenue on Jun 1.

Following the announcement its shares tumbled. And other residential REITs like AvalonBay Communities, Inc. (AVB - Free Report) , Essex Property Trust Inc. (ESS - Free Report) and UDR Inc. (UDR - Free Report) followed suit.

On the other hand, retail REITs could address the market slump even amid lackluster retail sales in the first quarter because of lower supply of new space.

Dividends Still Standing Tall

Dividends are by far the biggest enticement to invest in REIT stocks. As of Apr 29, the dividend yield of the FTSE NAREIT All REITs Index was 4.28% while the dividend yield of the FTSE NAREIT All Equity REITs Index was 3.86%. Clearly, REITs continue to offer decent yields and outpaced the 2.18% dividend yield offered by the S&P 500 as of that date.

Note that in addition to capital appreciation, yield-hungry investors continue to have a large appetite for REIT stocks as the U.S. law requires these to distribute 90% of their annual taxable income in the form of dividends to shareholders. This unique feature made the REIT industry stand out and gain a solid footing over the past 15–20 years.

Capital Access

REITs have also been proactive in the capital market in recent years, leveraging on a low rate environment to improve their financials. A total of $59.29 billion in public capital was raised by stock exchange-listed REITs in 2015. This indicates investors’ confidence in this sector and their willingness to pour money into it. Further, in 2016 through Apr 30, REITs have collected $23.4 billion in capital offerings.

Moreover, reforms to the Foreign Investment in Real Property Tax Act (FIRPTA) are expected to offer easy access to capital from foreign investors for publicly traded REITs and commercial real estate.

Zacks Industry Rank

Within the Zacks Industry classification, REITs are broadly grouped in the Finance sector (one of the 16 Zacks sectors) and are 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 265 industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry.

We put 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.)

The Zacks Industry Rank is #77 for REIT Equity Trust - Other, #105 for REIT Equity Trust - Retail, #159 for REIT Equity Trust - Residential, #185 for REIT Mortgage Trust.

Earnings Trends

Finally, with Q1 earnings season behind us, it is apparent that overall growth remained stressed. The broader Finance sector, of which the REITs are part, experienced a 7.0% decline in earnings from the same period last year on 2.7% higher revenues, with 59.1% beating EPS estimates and 53.4% coming ahead of top-line estimates. (Read: The Earnings Growth Challenge Continues)

For more information about earnings for this sector and others, please read our 'Earnings Trends' report.

However, in the real estate space, the trends have been different. In fact, total funds from operations (FFO) of listed U.S. Equity REITs succeeded in recording a 19.5% gain from the year-ago period and 8.3% from the prior quarter to $13.2 billion, per a May-released NAREIT T-Tracker report. This was backed by solid performance across many of the asset categories. Despite the lingering issues in the real estate market, this performance speaks volumes about the opportunities in the REIT industry.

Note: FFO, a widely used metric to gauge the performance of REITs, is obtained after adding depreciation and amortization and other non-cash expenses to net income.

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