The Federal Reserve has kept the target range for the federal funds rate at 0 to ¼% but raised the inflation projections for 2021. The central bank also indicated that the rate hikes could come earlier than what it had previously anticipated, forecasting two rate hikes by the end of 2023.
The dependence of REITs on debt for business makes investors skeptical about their performance in a rising rate environment. Also, the investment world treating REITs as bond substitutes for their high and consistent dividend-paying nature makes these companies susceptible to rising rates. This is why REITs’ price performance tends to fluctuate when the Fed is optimistic about raising rates.
However, before looking at the REIT space with a sceptic’s eye amid inflation and rate hike woes, let us rather dig into the fundamentals of this hybrid asset class.
Markedly, REITs provide natural protection against inflation. Particularly, both rents and real estate values have a tendency to move north with prices increasing, thereby aiding dividend growth. In fact, a majority of leases are tied with inflation, which leads to the rent increases as inflation goes up. Therefore, even amid the inflationary period, investment in the REIT industry can offer a steady stream of income. Notably, REITs' dividend increases have outstripped inflation as measured by the Consumer Price Index in all but three of the last 20 years, per a report by REIT.com.
Furthermore, over the years, REITs have managed their balance sheets efficiently and are now well prepared for a rising rate environment. Instead of looking for debt to finance the portfolios, these companies have strategically resorted to equity capital over the past decade.
This has helped the balance sheets of the overall REIT industry to become less leveraged in decades. Per the Nareit T-Tracker, the weighted average debt-to-book assets ratio of all REITs declined to 50.3% in first-quarter 2021 from the 58.3% seen in 2008, with REITs raising hundreds of billions of dollars of equity capital during this period.
Specifically, between 2009 and 2019, REITs raised a whooping total of $385 billion of common equity, comprising $28 billion of initial public offerings, $297 billion of secondary equity offerings, and $60 billion raised through at-the-market (ATM) equity programs. Apart from these, interest expense share of net operating income (NOI) declined to 21.6% in first-quarter 2021 from 38% in 2007.
Not only have the REITs reduced their exposure to interest-rate hikes, the companies also have opportunistically used the low-rate environment to make financials more flexible, which is encouraging down the line for their operational efficiencies. These REITs have, in fact, extended the maturity of their debt to 87 months presently from under 60 months in 2008, thereby locking the low rates for an elongated period.
Also, the Fed officials have increased their GDP projection to 7% for the current year compared with the March’s 6.5%. The central bank’s press release read, “Progress on vaccinations has reduced the spread of COVID-19 in the United States. Amid this progress and strong policy support, indicators of economic activity and employment have strengthened. The sectors most adversely affected by the pandemic remain weak but have shown improvement.”
This, in turn, boosts the real estate sector’s prospects as growth in the economy translates into greater demand for real estate, higher occupancy levels and landlords’ increased power to ask for higher rents. This is because one will eventually need “real space” for economic activities carried out in the real world or through virtual mode. Therefore, a REIT’s earnings, cash flow and dividend get a boost, as rate goes up amid economic growth. In fact, for most of the past 20 years, there has been positive correlation between interest rates and REITs’ stock-price movements.
4 Stocks to Scoop Big Gains
Here we’ve handpicked four REIT stocks that carry a favorable Zacks Rank of 2 (Buy), at present. These stocks have been witnessing upward estimate revisions. Also, their underlying asset categories display strength with the economy showing signs of recovery. Besides, don’t ignore the hiccups in stock prices, because these can provide solid entry points.
National Retail Properties, Inc. NNN is another retail REIT based in Orlando, FL, investing in high-grade retail properties subject usually to long-term, net leases. This retail REIT is well poised to benefit from the reopening of the economy. The current-year FFO per share consensus estimate has been revised 13.4% upward over the past two months, indicating an increase of 17.9%, year on year. Its dividend yield is 4.33%.
National Storage Affiliates Trust NSA is focused on ownership, operation and acquisition of self-storage facilities situated within the top 100 metropolitan statistical areas throughout the United States. This REIT is poised to gain from the healthy fundamentals of its asset category. The 2021 FFO per share consensus estimate moved 4.8% north in a month’s time, calling for an increase of 14.6%, year over year. Its dividend yield is 3.07%.
You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
Retail Properties of America, Inc. RPAI is engaged in owning and operating premium open-air shopping centers that are strategically located, as well as properties with a mixed-use component. The Zacks Consensus Estimate for the ongoing year’s FFO per share has moved up 4.9% upward over the last 30 days. It has a dividend yield of 2.27%.
Industrial Logistics Properties Trust ILPT is focused on the ownership and leasing of industrial and logistics properties, primarily in the United States. Healthy fundamentals of the industrial and logistics markets keep fueling the company’s growth. This REIT delivered a surprise of 6.82% during the January-March quarter in terms of funds from operations (FFO) per share. The Zacks Consensus Estimate for this year’s FFO per share has been revised 5% upward in two months’ time to $1.88. It has a dividend yield of 5.04%.
Here are the price performances of the above-mentioned REITs over the past six months.
Image Source: Zacks Investment Research
Note: Anything related to earnings presented in this write-up represent funds from operations (FFO) — a widely used metric to gauge the performance of REITs.
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