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Fed Makes Another Rate Cut: What Lies Ahead for REITs Now?

Moumita C. Chattopadhyay

As anticipated, the Fed cut the federal funds target rate by a quarter-point to 1.75-2.00% this time. The latest cut, which comes for the second time this year as well as in more than a decade, is aimed at sustaining the record-long economic expansion. Particularly, the central bank cited “the implications of global developments for the economic outlook as well as muted inflation pressures” as the key reason for lowering the target range.

However, in describing the current economic environment, the central bank recognized the labor market’s strength and indicated that economic activity has been rising at a “moderate” pace. With solid job gains, unemployment is hovering at low levels and household spending growth has been strong, though business-fixed investment and exports have weakened, per the Fed’s press release post its two-day meeting. Nevertheless, whether or not there will be another cut this year remains a question as the central bank members appear divided on the future course.

While the economic projections suggest a general trend of lower rates in the upcoming years, the longer-run expectations for fund rates remained unchanged at 2.5%. There has been a slight uptick in 2019 GDP growth rate expectations to 2.2% as against the 2.1% projected in June. Core inflation projection remained stable at 1.8% for 2019.  

No doubt, the historical dependence of REITs on debt for their business traditionally keeps them in the headlines when rate related announcements occur. Moreover, REITs are often treated as bond substitutes for their high-dividend paying nature.

Nonetheless, over the years, REITs have fortified their balance sheets, inclining more toward equity-capital raisings and lowering interest-rate exposures. Encouragingly, both in terms of book value and market value, leverage for the sector has declined to a two-decade low, per the Nareit T-Tracker.

Particularly, in 2007, 40% of REITs had a coverage ratio greater than 3x, while in 2019, 80% of REITs have a coverage ratio greater than 3x, highlighting the sector’s robust improvement in ability to cover fixed charges. Furthermore, in 2007, 81% of REITs had interest expenses that were higher than 40% of net operating income. Nonetheless, only 10% of REITs have such high interest expenses in the current year.

Low interest rate has, undoubtedly, played its part, but solid fundamentals and strong returns fueled its growth engine. Particularly, funds from operations (FFO) totaled $16.5 billion in second-quarter 2019, 13.5% higher than three years ago.

Moreover, the REIT sector has emerged as one of the most brilliant performers this year, with returns of the FTSE Nareit All REITs Index rallying 26.08% since the beginning of the year through Sep 18, outpacing the S&P 500 which gained 21.71% during the same period. Low unemployment, increasing wages and decent consumer sentiment are positive indicators for a number of asset categories, and the occupancy levels of properties are hovering near the record-high marks — indicating solid demand as well as scope for generating steady revenues.

With a favorable outlook, REITs were also able to issue $19.2 billion in secondary offerings of common equity during the first half of 2019. This is more than what the sector raised in full-year 2018, and if the trend continues in the second half of the ongoing year as well, there are possibilities of reaching a new record with respect to issuance for the sector.

Our Choices

Nevertheless, not all REITs are equally poised to excel as the underlying asset category and location of properties play a vital role in determining their performance. These stocks have been witnessing positive estimate revisions. In addition, their underlying asset categories display strength.

Innovative Industrial Properties IIPR, a Zacks Rank #2 (Buy) stock, focuses on the acquisition, ownership and management of specialized industrial properties leased to experienced, state-licensed operators for their regulated medical-use cannabis facilities. With more states in the United States giving cannabis the green light, Innovative Industrial Properties has incentive to acquire additional properties. Its expected FFO per share growth rate for 2019 is 92.54%.

Chicago, IL-based residential REIT Equity Residential EQR is focused on the acquisition, development and management of high-quality apartment properties in top U.S. growth markets. This Zacks Rank #2 stock is poised to excel as the apartment rental market’s fundamentals have been buoyed by a healthy job market, resilient consumer sentiment, household formation and high home-ownership costs in several markets, hindering transition from renter to homeowner. The company’s current-year estimated growth rate is 6.15%. The Zacks Consensus Estimate for 2019 FFO per share moved 1.8% north over the past 60 days.

You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Headquartered at San Mateo, CA, Essex Property Trust ESS is engaged in the acquisition, development, redevelopment and management of multi-family residential properties. Specifically, the company enjoys concentration of assets in select markets along the West Coast, which is home to several innovation and technology companies and the region is witnessing solid job growth, higher wages, increased percentage of renters than owners, and favorable migration trends. Essex Property Trust currently carries a Zacks Rank of 2. The residential REIT’s anticipated growth rate for 2019 is nearly 6%.

Alexandria Real Estate Equities, Inc. ARE owns, operates, and develops collaborative technology and life-science campuses mostly in coastal regions of the United States. The firm focuses on what it calls “innovation clusters,” which includes New York City, Greater Boston, Seattle, San Francisco, and a few other areas. The Zacks #2 Ranked stock’s FFO per share growth rate for the ongoing year is projected at 5.76%.

Here’s how the above stocks have performed in the year so far.

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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