Near-Term Outlook for Retail REIT Stocks Looks Bleak

Retail real estate investment trusts (REITs) are engaged in owning, developing, managing and renting space in a variety of retail real estates. These include regional malls, outlet centers, grocery-anchored shopping centers, as well as power centers which include big-box retailers. In addition, net lease REITs enjoy ownership of freestanding properties, wherein both rent and majority of operating expenses for the property are borne by the tenant.

The performance of the retail REIT industry depends on the economy's strength as well as the job-market scenario, as these determine consumers' spending capacity for buying retail goods and services. Also, purchase of retail goods and services takes place through multiple channels which play a crucial role in determining the demand for the retail real estate space. In fact, the rapid shift in customers' shopping preference to online channels, in recent times, has largely affected retailers' business model and kept retail REITs on tenterhooks.

Here are the three major themes in the industry:

Omni Channel Strategy: With e-commerce gaining market share from the traditional brick-and-mortar stores, retailers have been forced to reconsider their physical footprint and focus more on investing in online platforms, raising concerns over the fate of physical stores and landlords' cash flows. However, the latest trends highlight that omni-channel will continue to be point of focus for retailers. And physical stores will continue to remain an integral and effective sales channel despite the rising popularity of e-commerce.

In fact, though consumers prefer online retailing options, they also like to explore the option of visiting physical stores. Moreover, with options like free shipping and returns being offered with online sales, e-commerce has emerged as an expensive platform, affecting retailers' profit margin. This has prompted them to focus more on in-store pick up of online purchases (such as BOPS - buy-online, pick up in-store, and BOSS - buy-online ship-to-store), which increased significantly during the recent holiday season.

Additionally, retail real estate landlords are embracing digitally native brands and offering incentives, helping them open, operate and scale stores as a complement to e-commerce. Therefore, retailers that focus on omni-channel model are likely to grab more market share and REITs that support their real estate needs will benefit.

Improving U.S. Economy: The healthy U.S. economy and job-market gains are important catalysts for the industry's growth. Particularly, increase in corporate profits and tax cuts are pushing up wages. As such, consumer confidence is getting a boost, fueled by job growth and rising wages.

Along with low gas prices, disposable income of consumers has increased as well. This is evident from the 5.1% year-over-year growth in the retail sales figure for the 2018 holiday season, which marked the highest level in six years, according to Mastercard's SpendingPulse. This is anticipated to send across positive ripple effects across the industry.

Structural Changes to Continue: Nevertheless, changing consumer preferences will continue to have a considerable impact on retail business and affect real estate landlords. While right-sizing of footprints and store closures would persist, the ones unable to cope with competition will resort to bankruptcy filing. These will continue to lead to tenants demanding substantial lease concessions. In addition, the efforts of online retailers to penetrate deeper into the grocery business in recent years will likely result in a transformation of the grocery business, moving ahead.

However, retail REITs have been countering these challenges, transforming their traditional retail hubs into entertainment destinations and lifestyle resorts in a bid to lure customers. These REITs are avoiding heavy dependence on apparel and accessories, and instead expanding their dining options, opening movie theaters, as well as offering recreational facilities and fitness centers.

Furthermore, retail REITs are exploring the mixed-use development option as well, which has gained immense popularity, of late. Nonetheless, with huge outlay for refurbishments, growth in profit margins of retail REITs in the near term is likely to be affected.

Zacks Industry Rank Indicates Bleak Prospects

The Zacks REIT and Equity Trust - Retail industry is housed within the broader Zacks Finance sector. It carries a Zacks Industry Rank #161, which places it at the bottom 38% 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 2018 and 2019 moved down by 5.23% and 21.23%, 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 - Retail 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 declined 4.3% during this period compared to the S&P 500's fall of 5.8%. During the same time frame, the broader Finance sector has declined 12.5%.

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 Residential REITs, we see that the industry is currently trading at 13.94X compared to the S&P 500's forward 12-month price-to-earnings (P/E) of 16.24X. However, the industry is trading above the Finance sector's forward 12-month P/E of 13.30X. 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 19.44X, as low as 12.57X, with a median of 16.09X.

Bottom Line

In a nutshell, the retail REIT industry has scope for growth amid economic recovery and strong job market, low gasoline prices and high consumer spending, at present. However, concerns regarding cash flows of mall landlords amid declining mall traffic, store closures and retailers' bankruptcy filing, will likely prevail.

Of course, retail REITs' concerted efforts to boost productivity of retail assets by trying to grab attention from new and productive tenants, and disposing the non-productive ones are commendable, but huge outlays will continue to erode any near-term gains.

Nevertheless, as REITs strive to bring their mojo back, we handpick three stocks from the industry with a Zacks Rank of 2 (Buy) to add the Midas touch to your portfolio.

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

American Assets Trust, Inc. (AAT): This San Diego, CA-based American Assets Trust is a REIT engaged in acquisition, improvement, development and management of retail, office and residential properties throughout the United States. The company is slated to report its fourth-quarter and full-year 2018 earnings on February 12.

The Zacks Consensus Estimate for the 2018 funds from operations (FFO) per share remained unchanged at $2.09 cents, over the last 30 days. However, it indicates a projected increase of 8.9% year over year. Additionally, its 2019 FFO per share will likely witness year-over-year improvement of 4.2%.

National Retail Properties, Inc. (NNN): This retail REIT is based in Orlando, FL, and invests in high-grade retail properties subject usually to long-term, net leases. The company is expected to report quarterly numbers around Feb 12. The stock has seen the Zacks Consensus Estimate for 2018 FFO per share being revised marginally upward to $2.65, over the last 60 days. The company is also expected to witness nearly 4% year-over-year FFO per share growth in 2019.

STORE Capital Corp. (STOR): This net-lease REIT based in Scottsdale, AZ, is engaged in the acquisition, investment and management of Single Tenant Operational Real Estate (STORE properties). The company is expected to report quarterly numbers around Feb 28. The company's 2018 consensus estimate for FFO per share of $1.83, has been revised 1.67% north, in three months' time. In addition, its 2019 FFO per share will likely witness year-over-year improvement of 5.7%.

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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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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