Last Friday, Fed Chair Janet Yellen indicated there was a possibility of a gradual hike in interest rates sometime this year. Markets responded enthusiastically to these comments while sovereign yields increased marginally. Yields had struggled before the Fed Chair’s statements following lower-than-expected GDP numbers.
Gradual Rate Hike
At a conference sponsored by the San Francisco Fed, Yellen said that an improving economy “may warrant an increase in the federal funds rate target” at the end of the year. However, the Fed Chair added she and other FOMC members believe a “gradual rise in the federal funds rate” would be the correct approach “over the next few years.” At the same time, the Fed would evaluate the health of the economy through several economic indicators including real activity and inflation.
Yellen emphasized that rise in inflation rate is not essential for the Fed to hike interest rates. She was “cautiously optimistic” that economic growth will touch 2.3% in 2015, unemployment rate will drop further and consumer spending is expected to increase “at a good clip.”
GDP Disappoints
However, GDP numbers indicate some amount of slack in economic growth. Fourth quarter GDP increased at an annual rate of 2.2%, less than the consensus estimate of an increase by 2.4%. The report on fourth quarter GDP remained unchanged when compared to the "second" estimate issued last month. This rise in fourth quarter GDP was also less than the third quarter’s growth in real GDP by 5%.
Growth was hampered after business investment was trimmed, government spending dropped and trade balance deteriorated. Additionally, corporate profit after tax declined 3% from the third quarter, its biggest quarterly decline since first quarter of 2011. A stronger U.S. dollar and decline in global demand were cited to be the reasons responsible for the fall.
Will REITs Lose?
Real Estate Investment Trust (“REIT”) investors have had cause for concern. While an improving economy, particularly the labor market, has led to optimism, anticipation of the Federal Reserve’s tightening cycle has heightened fears. While positive data strengthens the industry’s fundamentals and builds demand for commercial properties, a rate hike would wipe out all the optimism.
Despite the recent hiccup, the long-term fundamentals of the economy remain strong. Better numbers in the next quarter would lift the spirit of market watchers once again. A rate hike after an economic recovery would significantly benefit REITs. This is because an improving economy would obviously mean more economic activity leading to increased demand for space. And since supply has been slow with tepid economic recovery in the past, this increase in demand would lead to higher rents and occupancies.
Additionally, the Fed cut its median funds rate forecast from 1.125% to 0.625% for the end of this year. Now, the Fed Chair has again emphasized the pace of rate increases would be gradual. This would give the REITs adequate time to adjust. Historically, REITs have a tendency of fitting with the market momentum and performing well over the long-term phase of rising rate. So if investors can gulp the short-term hiccups, the road ahead will drive up to gains.
Our Choices
Adjustments with the rate environment would be comparatively easier for sectors with the advantage of pricing power like hotel, storage and apartment REITs that have shorter-term leases. Below we present three stocks which will gain from these trends, each of which also has a good Zacks Rank.
Summit Hotel Properties, Inc. INN is an REIT engaged in the business of acquiring and owning limited, select-service and upscale hotels in the U.S.
Summit Hotel Properties holds a Zacks Rank #2 (Buy) and has expected earnings growth of 12.3%. The forward price-to-earnings ratio (P/E) for the current financial year (F1) is 13.05.
Chesapeake Lodging Trust CHSP is a self-advised REIT focusing on investments in upper-upscale hotels. These hotels primarily cater to business and convention segments and are located in urban settings in the US.
Apart from a Zacks Rank #2 (Buy), Chesapeake Lodging has expected earnings growth of 11%. It has a P/E (F1) of 14.52x.
Post Properties Inc. PPS is a developer and operator of upscale multi-family apartment communities in the U.S. The company owns several properties in metropolitan Atlanta, Dallas, Georgia, greater Washington D.C., Texas and Tampa, Florida.
Post Properties holds a Zacks Rank #2 (Buy) and has expected earnings growth of 20.8%. It has a P/E (F1) of 19.52x.
Given the long-term perspective on the U.S. economy, prospects for REITs remain strong. Moreover, a rate hike may be a good time to pick up such stocks and benefit from them at a later point. This is why these stocks would make for a prudent choice.
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