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Reality Bites for Retail REITs

By Igor Greenwald on September 7, 2017

Real Estate Investment Trusts, or REITs, benefit from one of the juiciest tax breaks around. They’re exempt from corporate income tax on the dividends distributed to shareholders, which for REITs must equal at least 90% of their taxable income.

As a result, the number of REITs and the capital invested in them have soared in recent years. The market value of publicly traded U.S. REITs topped $1 trillion by the end of 2016, more than doubling in five years. The number of REIT stocks dipped for the first time in eight years last year but, at 224, was still up 65% from the cyclical low in 2008.

In addition to the REITs’ tax advantage the investment boom was driven by the sector’s strong returns. U.S. REITs outperformed all other investment assets in 2010, 2011, 2012, 2014 and 2015.

Since 2015, the pace of gains has slowed and REITs’ performance has lagged the broad stock market. But it hasn’t been terrible. The FTSE NAREIT Equity REITs Index returned 8.5% in 2016 and 3.7% for 2017 as of  Aug. 31.

But the composite returns don’t tell the whole story. Beneath the placid surface, the REIT sector has been shaken by some seismic shifts in fortunes.

For owners of malls and shopping centers accounting for roughly 15% of REITs’ market capitalization this year has been a disaster. They were down 14% in the aggregate year-to-date, accounting for the bulk of the sector’s struggles. (Return numbers above and below are as of Aug. 31.)

Like their tenants, the retail REITs are suffering the downside of the accelerating shift from bricks-and-mortar stores to e-commerce. Amazon’s acquisition of Whole Foods and highly publicized discounting of select groceries at Whole Foods stores  has given investors another reason to worry about the future of supermarkets and the shopping plazas they anchor.

The flip side of that coin is that e-commerce requires a lot of computer servers, which in turn require real estate. The six REITs specializing in date centers have in the aggregate returned 32% year-to-date. 

Infrastructure REITS have returned 34% year-to-date, and that’s a subsector dominated by three owners of land underneath cell towers.

Other REITs are riding cyclical tailwinds. Those specializing in industrial properties are up 19% in 2017, while landlords renting out single-family and mobile homes have returned 16% and 22%, respectively. The much larger grouping of apartment building REITs returned 8% over the first eight months of this year.

REITs have historically traded in tandem with bonds but this year have failed to capitalize on the bond rally. It’s hard to blame the modest average REIT yield of around 4% when investors seem perfectly happy with barely half that from the data center and cell tower darlings. Retail REITs are now yielding almost 5%, which may not be enough given their steadily dimming long-term prospects.

The more generic risk is that, after failing to cash in on reduced bond yields of late, more investors will cash out when rates rise again. Until the yields improve, REIT buyers would do well to remain choosy.


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