Zacks Industry Outlook Highlights: RAIT Financial Trust, Terreno Realty, Physicians Realty Trust, Inland Real Estate and Campus Crest Communities

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Oct 20, 2014, 09:30 ET

CHICAGO, Oct. 20, 2014 /PRNewswire/ -- Today, Zacks Equity Research discusses the REITs (part 3), including RAIT Financial Trust (NYSE:RAS-Free Report), Terreno Realty Corp. (NYSE:TRNO-Free Report), Physicians Realty Trust (NYSE:DOC-Free Report), Inland Real Estate Corp. (NYSE:IRC-Free Report) and Campus Crest Communities, Inc. (NYSE:CCG-Free Report).

Industry: REITs (part 3)

Link: http://www.zacks.com/commentary/34909/stay-away-from-reits-despite-low-rates

The recent downtrend in interest rates and growing hopes that the Fed seems in no hurry start raising interest rates after they conclude the QE program have heartened REIT investors. But is this a good time to invest in the space? In an earlier piece (Right Time to Build Positions in REIT Stocks?), we provided the favorable arguments for investing in the REIT space, today's piece is dedicated to argue the opposite case.

The U.S. economic outlook has undoubtedly improved from the depressed levels of the first quarter of the year. But some of the more optimistic expectations in the market that look for sustained GDP growth in excess of +3% may be off the mark. The weak retail sales report for September and continued sluggish business trends show that banking on above-trend U.S. growth may be premature.

These questions about the U.S. outlook notwithstanding, the situation is worse in other key regions. Europe's growth hasn't materialized and the perception is gaining ground that the common currency is moving towards Japan-type environment of deflation and no growth. The European Central Bank has been unable thus far to come out with an adequate monetary policy response that will give investors confidence in the region's outlook. Beyond Europe, questions about China's growth aren't going away, and Japan's Abenomics experiment appears to be petering out.

All in all, the global economic backdrop is far from favorable. REITs need a stable and growing economic environment as this special hybrid class owns and operates real estates where people live, work, shop, dine and stay both in illness and while vacationing. So any adverse impact on people's purchasing power can result in a lower demand for the industry's services.

Choppy Markets

Not all REITs are the same and the outlook for some REIT sub-categories remains weak. For the residential REITs space, with the supply increases and modest job growth, the Metro DC area is expected to remain a pressing concern.

Even for the office REITs, though a recovery in full-swing is underway in markets with significant high-tech exposure, downtown Washington, DC and Midtown Manhattan are experiencing lower levels of activity and growth.

This is because these markets depend more on traditional tenants such as government, financials and law firms which presently are not major recruiters. Moreover, increasing space efficiency trends can crop part of the demand for additional space.

For the Hotel/Lodging REITs, while supply in the West Coast is low, a rise in supply in the East Coast has continued to dent RevPAR growth. The New York market, in particular, faced high levels of supply in the second quarter while hotels in Washington DC still had no respite with several properties experiencing a decline in the average daily rates compared with last year.

When Interest Rates Rise...

While the commitment of a low interest rate environment for a "considerable time" following the closure of the asset repurchase program was made by the Fed, no specifics were provided, leaving everyone in the lurch.

As discussed in an earlier piece, predictions of interest rate increases have proved wrong. But that doesn't mean rates will remain low forever. Given recent global growth and deflation fears, it is reasonable to expect interest rates to remain low, and perhaps even go even lower in the short run. But the eventual reversal of this trend, whenever that happens, will undoubtedly hurt the rate-sensitive REITs space, particularly if not accompanied with stronger economic growth.

Rising interest rates lead to an increase in interest costs as REITs usually look for both fixed and variable rate debt financing to pay back maturing debt and fund their development and redevelopment activities. In addition, amid rising interest rates, the common stock buyers demand a higher dividend yield. This may hurt the market price of the common stock.

Higher interest rates can particularly challenge healthcare REITs which have substantial exposure to long-term leased assets. Usually the assets under long-term triple-net leases carry fixed rental rates that are subject to annual bumps. But their debt obligations bear floating rates with interest and related payments rates varying with the movement of LIBOR, Bankers' Acceptance or other indexes.

Therefore, with the fixed-rate nature of most of these companies' revenues on the one hand and the rise in cost of debt on the other (when interest rates rise), the performance of the healthcare REITs can materially suffer and adversely impact the profitability and dividend payout.

Finally, though the mortgage REITs have started adjusting their strategies and business model, and have started shifting focus to shorter maturity securities, these companies bear long-term risk as interest rates will eventually rise.

Specific REITs that we don't like with a Zacks Rank #5 (Strong Sell) are RAIT Financial Trust (NYSE:RAS-Free Report), Terreno Realty Corp. (NYSE:TRNO-Free Report) and Zacks Rank #4 (Sell) Physicians Realty Trust (NYSE:DOC-Free Report), Inland Real Estate Corp. (NYSE:IRC-Free Report) and Campus Crest Communities, Inc. (NYSE:CCG-Free Report).

Bottom Line

The current uncertain market environment has enhanced the attractiveness of defensive and high-yielding industries like REITs. But investors should satisfy themselves by dispassionately absorbing both sides of the argument and then make a decision. The industry no doubt has many positives, but there is no shortage of issues either.

Check out our latest REIT Industry Outlook here for more on the current state of affairs in this market from an earnings perspective, and how the trend is looking for this important sector of the economy now.

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