2017's Best Asset Class Isn't What You'd Think

Genia Turanova's picture

Monday, January 9, 2017 - 12:00am

by Genia Turanova

As we enter 2017, between the incoming rate hikes and improved growth expectations, it looks as if new opportunities are developing among Real Estate Investment Trusts, or REITs.

These stocks offer a simple way to invest in real estate for income as well as growth. REITs are designed to benefit from the attractive fundamentals of real estate, without saddling smaller investors with the high capital requirements and low liquidity of actual houses or other physical assets. Through various REITs, an investor can simultaneously become a landlord in an apartment complex 500 miles away, an owner of a high-end shopping center, or a self-storage entrepreneur, without the hassle of actually running these businesses.

A REIT structure allows investors to not only benefit from the long-term value appreciation of all these assets, but it also enables them to get their share of income. The high returns offered by some REITs fit perfectly with the goal of my premium newsletter, The Daily Paycheck: to provide my readers with fat monthly dividend checks.


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Publicly traded REITs, as you might recall, have been moved into their own S&P 500 category as of last fall. Many market observers had anticipated that the stocks in the newly formed Real Estate S&P 500 sector -- the sector that is focused on REITs -- would rally strongly as the Real Estate sector was separated from financials.

Markets trade on expectations, though, and much of the bullish move had happened in anticipation of the September sector unveiling, leaving no gains to be found after the fact. In the fourth quarter of 2016, REITs, as represented by the Dow Jones Equity REIT Total Return Index, declined by about 3.2%. The good news is that the sector, even with that negative quarter, was positive for the year, up about 8.9%.

There is no question, too, that the recent decline is related to anticipated increases in interest rates. REITs are an income sector, and investors' interest in these stocks has declined as yields on Treasury bonds have risen.

Moreover, conventional wisdom tells us that higher interest rates should hurt real estate: Borrowing costs -- literally the costs of doing business for REITs -- are moving higher, thus hurting profits and business outlook across the sector.

But the price decline among REITs, coupled with the perception that higher rates are a serious headwind, has created some buying opportunities.

I say "opportunities" because I think that, while interest rates are a very important factor for REITs, the sector is not that much different from the rest of the stock market: REITs, as with all stocks, ultimately trade on expectations for future profits.

Granted, these profits depend on how quickly REIT companies can raise rents to compensate for the higher interest rates. But rising property prices are also good for REITs because they translate to more assets (measured in dollars) without buying or building new properties.

A better economy, even with higher interest rates, implies a much better outlook for the sector than a declining one, when costs are low but credit is sparse. Plus, because so many REITs have deleveraged in the past few years, the sector's strong balance sheets will make it easier to borrow.

The outlook for 2017 now calls for economic growth and higher inflation, propelled by expected tax cuts, banking deregulation and fiscal stimulus. Taken together, these factors are shaping up to help the REIT sector rather than hurt it.

And if you need an expert's opinion, how about the word of Nobel laureate and author of the Case-Shiller index of housing prices, Robert Shiller? On Dec. 27, Shiller said in a Bloomberg TV interview that a "Trump boom" might be coming for the U.S. housing market. He didn’t go quite far enough to say that it certainly would, but he believes the opportunity is there.

Of course, just as not all business sectors are equally leveraged to the 2017 economy, neither will all REITs will benefit from it.

The REITs that are best-positioned for the challenges of the higher inflation and higher interest rate environment are those in a position to raise rental rates. The stability of many healthcare-related REITs, with their long-term leases, is not ideal.

However, companies that operate in businesses with high barriers to entry and/or expanding markets shouldn’t have much trouble raising rents. One example: Digital Realty Trust, Inc. (NYSE: DLR), a REIT that operates in a growing data center business.

DLR’s business is strong and seems to be getting stronger. In the company's latest quarter, new lease signings were the strongest since 2014. Looking forward, DLR was confident that it had a strong pipeline of future deals.

But even more promising are those companies that offer shorter-term leases. My most recent pick, a REIT that owns many short-term rental facilities, passes muster when it comes to offering both growth prospects and compelling value.

After a recent re-brand, this REIT has increased its same-store net operating income (NOI) by 9.6%, benefitting from the accelerating effective rent growth and high occupancy levels. It's also been able to effectively position itself in growing markets while avoiding those with more stagnant growth.

In terms of Funds from Operations (FFO), a standard metric for valuing REITs (which is essentially net income, excluding gains or losses from sales of property, plus depreciation and amortization), this pick has outperformed expectations in each of its past 8 quarters.

At this time, it seems to be an attractively valued REIT, well-positioned for growth and poised to outperform its peers in a rising interest rate environment. Unfortunately, this pick is only available to my The Daily Paycheck subscribers. If you want to learn how to get it, and keep up with all of my other analysis as 2017 comes into focus, I invite you to follow this link.

 

Genia Turanova does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.