Why All Is Not Well with REITs

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Fed-centric issues have no doubt taken center stage, triggering off volatility in REIT stock prices. However, weakness in certain categories of the real estate market cannot be denied either.

Sector Weakness

In fact, the overall holiday season was quite disappointing for retailers this time, with the only bright spot being a rise in online sales. Ironically, increasing consumer spending on online platforms has emerged as a pressing concern for retail REITs, as the trend is curtailing demand for retail real estate space.

Moreover, in spite of economic improvement and a recovery in the job market, which is expected to boost demand for office spaces, excess supply of available space has kept the office market fundamentals under pressure. On top of that, persistent office space efficiency trends may limit any potential recovery in its fundamentals in the near term.

For apartment REITs, increased supply in many of the markets raises an alarm. This is because higher supply usually 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.

In fact, according to Axiometrics' apartment data, while 2015 was strong for the apartment market, moderation was noted toward the end with national annual effective rent growth coming in at 4.3% in December, reflecting a 28 basis points (bps) decline from the November tally.

Moreover, strengthening of the dollar add to the woes. Due to a strong dollar, properties situated outside the country are being adversely impacted. In addition, U.S. exports have become more expensive and are therefore losing value on the competitive landscape. This can be detrimental to REITs as corporate leaders now have to deal with unfavorable currency movements and think twice before expanding their business.

Rates Cannot Stay Low Forever

Finally, a low rate environment cannot be a perpetual one. While the recent bout of soft economic data raised doubts over the probability of a March hike and on the number of such raises in 2016, the latest mixed labor market report for January - with the non-farm payroll reading coming short of estimates amid increased participation, rise in wages and decrease in the unemployment rate - heightens Fed uncertainty.

But when the rates go up, borrowing costs for REITs would increase as these companies usually look for both fixed and variable rate debt financing to pay back maturing debt, and fund their acquisitions, development and redevelopment activities. So rising rates could affect these companies' ability to purchase or develop real estate and lower their dividend payouts as well. Moreover, the dividend payout itself might turn out less attractive than the yields on fixed income and money market accounts.

REITs cannot practically run away from the impact of a rate hike. But the extent of such an impact would depend on the nature of their leases and funding activities. While REITs having shorter leasing periods have the power to adjust their rent quickly to adapt to the rates hike, those with longer leasing periods are left in the lurch.

Take for example health care REITs that usually have significant exposure to long-term leased assets. The long-term leases carry fixed rental rates that are subject to annual bumps. But their debt obligations bear floating rates with interest and related payment rates varying with the movement of LIBOR, Bankers' Acceptance or other indexes. Therefore, as the rates rise, the cost of borrowing increases but their revenue flows do not get adjusted quickly for their fixed-rate nature, leading to an adverse impact on profitability.

Consider Mortgage REITs that 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 Five Oaks Investment Corp. ( OAKS ), EDR ( EDR ) and Cyrusone Inc. ( CONE ) with a Zacks Rank #5 (Strong Sell). Also, we would like to avoid Zacks Rank #4 (Sell) stocks such as Ares Commercial Real Estate Corporation ( ACRE ), CYS Investments, Inc. ( CYS ), American Campus Communities, Inc. ( ACC ), American Assets Trust, Inc. ( AAT ), RLJ Lodging Trust ( RLJ ), National Health Investors Inc. ( NHI ), Pebblebrook Hotel Trust ( PEB ) and Piedmont Office Realty Trust Inc. ( PDM ).

Bottom Line

Despite having many positives, there is no shortage of negative factors. Therefore, 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.

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RLJ LODGING TR (RLJ): Free Stock Analysis Report

PEBBLEBROOK HTL (PEB): Free Stock Analysis Report

PIEDMONT OFFICE (PDM): Free Stock Analysis Report

FIVE OAKS INVST (OAKS): Free Stock Analysis Report

NATL HEALTH INV (NHI): Free Stock Analysis Report

EDUCATION RLTY (EDR): Free Stock Analysis Report

CYS INVESTMENTS (CYS): Free Stock Analysis Report

CYRUSONE INC (CONE): Free Stock Analysis Report

ARES COMMERCIAL (ACRE): Free Stock Analysis Report

AMER CAMPUS CTY (ACC): Free Stock Analysis Report

AMER ASSETS TR (AAT): 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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