Last year, the U.S. real estate investment trust (REIT) industry stole much of the limelight -- for reasons both good and bad.

On the positive side, the creation of an exclusive headline sector for real estate under the Global Industry Classification Standard not only reflected the growing importance of real estate in the global economy but also raised expectations of drawing in billions and pushing up valuations over time. However, on the negative side, rate hike concerns and the bond market rout amid Trump’s promise of strong fiscal stimulus spread jitters in the industry. The Zacks REIT industry’s +2.5% gain since November 8^th vs. the +6.1% gain for the S&P 500 index in that time period reflects these jitters.

The FTSE/NAREIT All REIT Index registered in a total return of 9.28% for the entire year, which could not match the stellar performance of the S&P 500 that gained 12% from the Trump Rally. Specifically, Equity REITs, which comprised over 94% of the total REIT market at the end of 2016, came up with a weak performance, with the FTSE NAREIT All Equity REIT Index finishing the year with a total return of 8.63%.

Rebounding Returns in December

But what drew attention was that in December, when the rate hike finally took place, there was a rebound in returns after four straight months of downturns, with the FTSE/NAREIT All REIT Index gaining 4.2% and outpacing the S&P 500’s 2.0% increase. This reflected the easing of rate hike fears, but also suggested the growing appetite of long-term investors for undervalued REIT stocks with solid prospects.

What’s in the Cards?

Moving ahead, rate hike and treasury yields would surely remain a talking point in the industry, because REITs are still dependent on debt for their business. Also, they are often considered as bond substitutes for their high and recurring dividend paying nature.

But assuming that the entire industry would falter altogether in a rising rate environment would be wrong. Because, REITs cater to a wide range of real estates and each asset category has its own demand-supply dynamics that end up playing a vital role in determining the performance of REIT stocks.

Also, the pace and magnitude of rate hikes, and the capacity of REITs to absorb those increases are expected to substantially shape the REIT industry’s outlook. Therefore, things like lease durations and pricing power in the market would command much attention.

Of course, fiscal stimulus like tax reduction and infrastructure spending expected under Trump’s presidency are likely to boost demand, fuel economic growth and push up inflation. And when economic growth gathers steam and inflation rises, prices of real estate generally increase while rent and occupancy of properties go up. But not every category of real estate is likely to get an equal boost and not all locations are equally poised to flourish.

This was quite evident in the fourth quarter when office and industrial asset categories continued to experience high demand, though supply issues in a number of markets like New York and San Francisco raised concerns for some of the residential REIT stocks. Also, dwindling mall traffic and store closures amid aggressive growth in online sales kept retail REITs on tenterhooks.

So investors need to remain cautiously optimistic and look beyond the rate factor. It is important to first study the fundamentals of the underlying asset category before making any investment.

Dividends Standing Tall

Nevertheless, dividends are by far the biggest attraction to invest in REIT stocks, and income-seeking investors continue to find reasons to prefer them. This is because, as of Dec 30, 2016, the dividend yield of the FTSE NAREIT All REIT Index was 4.32%, which handily outpaced the 2.1% dividend yield offered by the S&P 500 as of that date.

Among the REIT market components, the FTSE NAREIT All Equity REIT Index enjoyed a dividend yield of 3.96% while the FTSE NAREIT Mortgage REITs Index had a dividend yield of 10.60%. Over long periods too, REITs have outperformed the broader indexes with respect to dividend yields.

U.S. law requires REITs to distribute 90% of their annual taxable income in the form of dividends to shareholders. This unique feature made the industry stand out and gain a solid footing over the past 15–20 years.

Capital Access

Further, in recent years, REITs managed their balance sheets well and focused on lowering debt and extending maturities. As a result, the debt-to-total market capitalization of the Equity REIT market reached 31.9% on Sep 30, 2016, marking the lowest level in 20 years.

Also, REITs have indeed been proactive in the capital market, with the stock exchange-listed REITs raising a total of $59.3 billion in public capital in 2015 and collecting $69.6 billion in capital offerings in 2016.

Moreover, reforms to the Foreign Investment in Real Property Tax Act (FIRPTA) are expected to offer easy access to capital from foreign investors for publicly traded REITs and commercial real estate.

Zacks Industry Rank

Within the Zacks Industry classification, REITs are broadly grouped in the Finance sector (one of the 16 Zacks sectors) and are further sub-divided into four industries at the expanded (aka "X") level: REIT Equity Trust - Retail, REIT Equity Trust - Residential, REIT Equity Trust - Other and REIT Mortgage Trust. The level of sensitivity and exposure to different stages of the economic cycle vary for each industry.

We rank 265 industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry.

We put our industries into two groups: the top half (industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank). Over the last 10 years, using a one-week rebalance, the top half beat the bottom half by a factor of more than 2 to 1. (To learn more visit: About Zacks Industry Rank.)

The Zacks Industry Rank is #91 for REIT Mortgage Trust, #138 for REIT Equity Trust – Other, #193 for REIT Equity Trust – Residential and #216 for REIT Equity Trust – Retail.

Earnings Trends

We are in the heart of the Q4 earnings season and results from 171 S&P 500 index members already out. So far, the finance sector, of which REITs are part, has revealed strength and better-than-expected results. Results from 57.9% of the sector’s market cap in the S&P 500 index are already out and total earnings have increased 11.3% year over year backed by 3.1% higher revenues, with 67.5% beating EPS estimates and 45% exceeding top-line estimates. (Read: Is the Bar Higher for the Q4 Earnings Season?)

For more information on earnings for this sector and others, please read our 'Earnings Preview' report.

REITs Worth Adding

Over the last six month, the industry lost over 9.5% compared with the S&P 500’s gain of 5.2%. As the industry significantly underperformed the broader market, there is a solid value-oriented path ahead.

Investors can consider the following REIT stocks that have solid fundamentals to weather any rate hike. Also, their favorable Zacks Rank and decent dividend yield makes them solid picks.

CoreCivic, Inc. , formerly the Corrections Corporation of America, provides correctional, detention and residential reentry facilities. With positive estimate revisions over the past two months and a dividend yield of 5.79%, CoreCivic can be a solid addition to one’s portfolio. The stock currently has a Zacks Rank #1 (Strong Buy). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Sunstone Hotel Investors, Inc. (SHO Quick QuoteSHO - Free Report) is a lodging REIT that has a portfolio of hotels which are mainly in the upper upscale segment. The hotels are usually operated under brands – such as Marriott, Hilton, Fairmont and Hyatt. This Zacks Rank #2 (Buy) stock has a dividend yield of 14.4% and is a steady performer having beaten the Zacks Consensus Estimate in all four trailing quarters with an average beat of 6.81%.

W. P. Carey Inc. (WPC Quick QuoteWPC - Free Report) is a REIT engaged in providing long-term sale-leaseback and build-to-suit financing for companies. It has a Zacks Rank #2 and a dividend yield of 6.39%. It is also steady performer having exceeded the Zacks Consensus Estimate in each of the four trailing quarters with an average beat of 15.81%. The stock is also experiencing positive estimate revisions over the past two months.

Annaly Capital Management, Inc. (NLY Quick QuoteNLY - Free Report) is a mortgage REIT and currently has a Zacks Rank #2. It has a dividend yield of 11.74%. It is a solid buy pick and the stock is trading at a discount to the industry average.

 

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