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Why Investments in REIT Stocks Can Be Risky

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Despite being backed by many positives, there is no shortage of negatives for the REITs. In fact, any hike in rate has the capability to trigger volatility in REIT stock prices. But weakness in the underlying asset categories of the REITs can dull their results. So, prior to investing in REIT stocks, one needs to pay a close attention to all the weaknesses and judge the stocks prudently.

Sector Weakness

Residential REITs have grabbed investors’ attention over the past few years. In fact, apartment demand has been high with favorable demographic growth in the millennial generation that has a high propensity to rent, rising household formation and elevated homeownership cost. But lately, things got worse for the residential REITs as increased supply in many of the markets raised an alarm.

These REITs witnessed a significant sell-off over the past few days following a guidance cut for 2016 same store revenue by Equity Residential (EQR) on Jun 1, citing continued weakness in New York and the recent downturn in the San Francisco portfolio. Equity Residential has blamed new rental apartment supply for hurting its rent growth. (Read: Equity Residential Lowers Guidance Amid Market Weakness)

Usually higher supply curtails the landlord’s ability to demand higher rents and leads to lesser absorption. Also, there is competition from the single-family housing market. These may keep the growth momentum of rent at check.

Moreover, recovery in the industrial market has continued for long. The CBRE Group Inc. study revealed that the first-quarter 2016 decline in the availability rate marked the 24th consecutive quarter of decreasing availability. So chances of any striking decline in availability rates are less. Also, a whole lot of new construction is expected over the next two years that can put a pause on growth next year.

Further, retailers’ results in the last reported quarter were disappointing, with particularly, a number of traditional brick-and-mortar operators falling shy of estimates. Despite decent consumer spending trends and a number of retailers coming out with so-called omni- and multi-channel strategies, this outcome reflects the failure of retailers to come forward with an attractive alternative to online retailers. This has emerged as a pressing concern for retail REITs, as the trend is curtailing demand for the retail real estate space.

Apart from these, the recent job data were not assuring. This combined with excess supply in a number of markets amid modest demand is likely to limit growth in rents. On top of that, persistent office space efficiency trends may limit any potential recovery in its fundamentals in the near term.

Rates Hike Outlook

The low interest rate environment appears to be firmly in place for now, with benchmark treasury yields appearing to be going back to prior lows. The Fed did the expected in their today, leaving rates unchanged and lowering their outlook for long-term interest rates. Many in the market now see the Fed not budging in next month’s meeting either, with many seeing the December 2016 meeting as the next opportunity for the next rate hike.

This near-term favorable backdrop notwithstanding, the long-term outlook for rates is for higher. The eventual rise in interest rates will no doubt be a burden for debt-dependent REITs. Moreover, the dividend payout itself might turn out less attractive than the yields on fixed income and money market accounts.

Take for example the health care REITs that usually have significant exposure to long-term leased assets which carry fixed rental rates that are subject to annual bumps. With raised rates, the cost of borrowing will increase but their revenue flows will not get adjusted quickly for their fixed-rate nature, leading to an adverse impact on profitability.

Also, volatility in rates can spell trouble for mortgage REITs, 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 their mortgage assets and their funding costs. Though these types of REITs have started adjusting their strategies and business models, they bear long-term risk as interest rates will eventually rise.

REITs to Avoid

Specific REITs that we don't like include Western Asset Mortgage Capital Corporation , Walter Investment Management Corp. , Great Ajax Corp AJX and AG Mortgage Investment Trust, Inc. (MITT - Free Report) with a Zacks Rank #5 (Strong Sell).

Also, we would like to avoid Zacks Rank #4 (Sell) stocks such as Resource Capital Corp. , Hatteras Financial Corp ,Camden Property Trust (CPT - Free Report) , Select Income REIT , UDR, Inc. (UDR - Free Report) , Rouse Properties, Inc. RSE, WP GLIMCHER Inc. , Ashford Hospitality Trust, Inc. (AHT - Free Report) , Chatham Lodging Trust (CLDT - Free Report) , Farmland Partners Inc. FPI and Four Corners Property Trust, Inc. FCPT.

Bottom Line

Finally, investors should satisfy themselves by dispassionately absorbing both sides of the argument and then call the shots.

Check out our latest REIT Industry Outlook here for more on the current state of affairs in this market from an earnings perspective.