Volatility has notably increased for real estate investment trust (REIT) investors as a result of the growing likelihood of the coming Fed tightening and the associated jump in treasury yields.
Driving this trend is the expectation of growth resumption for the U.S. economy following the weak showing in the first quarter. Recent economic data points, ranging from factory sector ISM survey, housing surveys and monthly automobile sales, have all been encouraging.
The improving labor market has been the icing on the economic cake, with the May non-farm payroll report not only showing better-than-expected job numbers, but also gains in average hourly earnings. Adding to the delight were the latest retail sales numbers that surged in May and the consumer credit numbers that showed growth in U.S. consumer debt in April.
We will know more after this week’s FOMC meeting, but the consensus expectation is that these improving economic indicators have increased the odds of a rate hike in September, notwithstanding the IMF’s request to delay the first rate hike for some time next year.
REITs Take a Hit
Though the REIT industry emerged as a winner last year among widespread volatility, and even outperformed the broader equity market in January, the FTSE NAREIT All REIT Index’s total return dipped 0.1% in May against the S&P 500’s gain of 1.3%.
This followed a decline of 4.7% in April compared with the S&P 500’s return of 1.0%. While volatility seems to have eaten away much of the broader equity market gains in the second quarter, the impact on the REIT stocks has been more pronounced.
Rising Rates and Economic Strength
A rise in interest rates will undoubtedly lead to a high borrowing cost for the REITs on which they are highly dependent. Moreover, high-dividend yielding stocks like REITs usually become less attractive when treasury yields rise.
But that does not take away opportunities from this sector. This is because the REITs business is tied to the basic necessities of life such as food, housing and health care without which we cannot live for long. They offer real estate on rent for dwelling proposes, warehousing, shopping, dining, vacationing and advertising too.
As Fed plans for a rate hike only when the economy gains strength, employment level improves and inflation reaches 2%, we believe this would open up opportunities for the REIT sector to leverage from improving economic fundamentals. This is because stepped-up economic activity also stimulates corporate spending, leading to increased hiring and this greater workforce would need more space for accommodation.
Also, enhanced purchasing power drives more spending on part of individual consumers. This translates into increased industrial activity while their distribution needs logistic facilities, thereby increasing demand for real estate. A fatter wallet also means better rent-paying ability that drives demand for apartments. As a result, REITs stand to gain with growth in occupancy and hike in rents.
But not all markets are equal. A close introspection is needed as the worth of any REIT stock depends much on the asset type in which it invests as well as on the local economy. Therefore, ignoring the short-term jerks, investing in fundamentally strong REIT stocks could be a prudent decision. And the hiccups might offer solid entry points.
In this environment, one could bet on top-ranked stocks like Agree Realty Corp. (NYSE:ADC), Arbor Realty Trust Inc. (NYSE:ABR), Armada Hoffler Properties, Inc. (NYSE:AHH), Cedar Realty Trust, Inc. (NYSE:CDR), Equity LifeStyle Properties, Inc. (NYSE:ELS), Excel Trust, Inc. (NYSE:EXL), Extra Space Storage Inc. (NYSE:EXR), Hospitality Properties Trust (NYSE:HPT), Select Income REIT (NYSE:SIR), Strategic Hotels & Resorts, Inc. (NYSE:BEE), Walter Investment Management Corp. (NYSE:WAC) and ZAIS Financial Corp. (NYSE:ZFC).
Dividends Still Standing Tall
The U.S. law requires REITs to distribute 90% of their annual taxable income in the form of dividends. This has been the biggest enticement for the REIT stocks to gain traction in the recent past amid global uncertainties, both in the money and commodities markets. Though REITs have taken a beating of late, their dividend yield came in better than that of the market.
In fact, as of Apr 30, the dividend yield of the FTSE NAREIT All REITs Index was 4.00% while the yield of the FTSE NAREIT All Equity REITs Index was 3.57%. Clearly, the REITs continued to offer decent yields and outpaced the 2.01% dividend yield offered by the S&P 500 as of that date.
Capital Access
REITs were proactive in the capital market in 2014 and are still so in 2015. They have opportunistically drawn leverage from the low rate environment for refinancing their debts, which is encouraging. Also, this indicates the rise in investors’ confidence in this sector and their willingness to pour money into it.
As of April 30, 2015, REITs raised $28.3 billion in initial, debt and equity capital offerings (IPOs - $1.2 billion, Secondary Common - $14.5 billion, Secondary Preferred - $1.8 billion and Secondary Debt - $10.8 billion).
Zacks Industry Rank
In the Zacks Industry classification, REITs are broadly grouped into the Finance sector (one of 16 Zacks sectors) and further sub-divided into four industries at the expanded level: REIT Equity Trust - Retail, REIT Equity Trust - Residential, REIT Equity Trust - Other and REIT Mortgage Trust.
Based on the earnings outlook for the constituent companies in each industry, we rank all of the 260+ industries in the 16 Zacks sectors. This ranking is available on the Zacks Industry Rank page. http://www.zacks.com/stocks/industry-rank
As a point of reference, the outlook for industries with Zacks Industry Rank #88 and lower (the top one-third of the list) is 'Positive,' between #89 and #176 is 'Neutral,' and #177 and higher (the bottom one-third) is 'Negative.'
The Zacks Industry Rank for REIT Mortgage Trust is #57, REIT Equity Trust - Retail is #76, REIT Equity Trust - Residential is #78 and REIT Equity Trust - Other is #92. Looking at the Zacks Industry Rank for different REIT segments, it is obvious that the outlook for this industry as a whole is in the positive-to-neutral zone.
Earnings Trends
The broader Finance sector, of which the REITs are part, witnessed a 16.5% uptick in earnings from the comparable period prior year on 2.0% higher revenues, with 63.9% beating EPS estimates and 50.6% coming ahead of revenue expectations. In fact, the Finance sector was a notable contributor in the first quarter with solid earnings from several of the Wall Street majors.
Despite a downward revision in estimates for the overall S&P 500 companies, the Finance sector stands out. Total earnings for this sector are projected to be up 2.7% year over year in the second quarter of 2015. Things are expected to improve further for the overall Finance sector from the next quarter, with 9.8% earnings growth expected for the third quarter, 16.2% for the fourth quarter and 13.6% for full-year 2015.
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