Besides Interest Rates, Here's Why REIT Investments Seem Risky

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Indications from Fed officials on raising the key interest rate multiple times over the next two years have spread jitters in the REIT industry. The bond rout has also added to its woes. Together with this, the performance of REITs can be clouded by the weakness in the underlying asset categories. Therefore, unless close attention is paid to all the weaknesses before investing in REIT stocks, one can end up incurring big losses.

Fundamental Weakness

In fact, supply issues in a number of markets have raised the alarm for many residential REIT stocks. Markets with high rents like San Francisco and New York have been much affected and the high end and luxury apartment categories are flooded with new supply. But higher supply usually curtails landlords' ability to demand higher rents and leads to lesser absorption. There is also a trend of increased concessions in San Francisco and the New York City market.

Reflecting such weaknesses, in Q4, national effective rent growth increased 2.3% according to early apartment data from AXIOMetrics. This was over 2 percentage points lower than the 4.6% rent growth experienced in the year-ago quarter. Also, occupancy of 94.7% in the fourth quarter was down from 95.1% in the third quarter and 95.0% in fourth-quarter 2015. Furthermore, there seems to be no respite from the situation anytime soon and the moderation is anticipated to continue this year too with a whole lot of new construction slated to be delivered.

Further, though upbeat consumer confidence and an improving economy have infused optimism into the retail market, mall traffic continues to suffer amid a rapid shift in customers' shopping preferences and patterns with online purchases growing by leaps and bounds. These have made retailers reconsider their footprint and eventually opt for store closures like that of Macy's (M).

Also, retailers that are not being able to cope with competition are filing bankruptcies. This is a pressing concern for retail REITs, as the trend is curtailing demand for the retail real estate space considerably.

Moreover, in this era of technology, with retailers embracing the omni-channel concept, retail real estate landlords are compelled to give their malls a facelift in a desperate attempt to lure customers. They are also adapting to latest technologies to offer attractive services to their tenants and mall visitors. However, the implementation of such measures requires a decent upfront cost and, hence, is likely to curtail any robust growth in the profit margins of retail REITs in the near term.

In the self-storage industry too, rising supply in some of the markets is affecting revenue growth. On the other hand, though the U.S. industrial real estate market is on the lengthiest stretch of recovery, with availability falling for 26 straight quarters to 8.2% in the fourth quarter, the gap between supply and demand "was the tightest since 2010" according to the CBRE Group study . Also, subsequent to a solid beginning to the year, fourth-quarter demand witnessed a decline, with positive net absorption of 47.0 million square feet falling 41% sequentially and 36% year over year.

Amid all this, chances of any robust improvement in rent and occupancy growth in the upcoming period for industrial assets seem limited. Also, a whole lot of new buildings are slated to be completed and made available in the market this year and in the next, leading to higher supply and lesser scope for rent and occupancy growth, going forward.

When Rates Move Up Steadily

Finally, rates will eventually go up and this will no doubt be a burden on the debt-dependent REITs. Moreover, the dividend payout itself might turn out less attractive than the yields on fixed income and money market accounts in event of a rate hike.

Apart from this, health care REITs are at risk with rates moving north. This is because these REITs usually have significant exposure to long-term leased assets which carry fixed rental rates that are subject to annual bumps. Therefore, as the rate goes up, 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.

Further, volatility in rates can cast a pall on mortgage REITs or mREITs, 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 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.

Bottom Line

Therefore, before calling the shots, investors should satisfy themselves by dispassionately absorbing both sides of the argument.

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

REITs to Avoid

Specific REITs that we don't like include Pennsylvania Real Estate Investment Trust (PEI), Hersha Hospitality Trust (HT), Healthcare Realty Trust Inc. (HR) and Select Income REIT (SIR).

Pennsylvania Real Estate Investment Trust, a retail REIT, presently has a Zacks Rank #5 (Sell). Its estimates for 2017 have experienced downward revisions over the past three months, reflecting the bearish sentiment of analysts on this stock.

Hersha Hospitality Trust, a lodging REIT, has a Zacks Rank #5. Its full-year 2017 estimates too experienced a southward revision over the past two months.

Healthcare Realty Trust Inc., a healthcare REIT, presently has a Zacks Rank #4 (Sell). The company came up with lower-than-expected performance in the prior quarter. Its long term growth rate of 4.0% is below the industry average of 5.7%. Also, its estimates for 2017 have experienced downward revisions over the past three months.

Select Income REIT, which is engaged in primarily owning and investing in net leased, single tenant properties, has a Zacks Rank #4. Its long-term growth rate of 5.6% is below the industry average of 7.4%. Select Income REIT also witnessed negative revision to its 2017 estimates over the past three months.

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

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Select Income REIT (SIR): Free Stock Analysis Report

Pennsylvania Real Estate Investment Trust (PEI): Free Stock Analysis Report

Macy's Inc (M): Free Stock Analysis Report

Hersha Hospitality Trust (HT): Free Stock Analysis Report

Healthcare Realty Trust Incorporated (HR): Free Stock Analysis Report

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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