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Dwindling foot traffic, store closures and retailers’ bankruptcy filings, which have been further aggravated by the coronavirus crisis, will continue to affect cash flows of Zacks REIT and Equity Trust - Retail constituents in the days to come.

Nevertheless, reopening of the economy is reinstating some confidence, while positive developments on the COVID-19 vaccine front further raises hopes for this industry. Moreover, focus on tenants from essential retail and e-commerce resistant sectors have been the saving grace for retail REITs, including Realty Income Corp.(O), Agree Realty Corp. (ADC) and Retail Opportunity Investments Corp.(ROIC).

About the Industry

The Zacks REIT and Equity Trust - Retail industry represents a group of REITs that are engaged in owning, developing, managing and renting space in a variety of retail real estates. Among these retail real estate assets are regional malls, outlet centers, grocery-anchored shopping centers, as well as power centers which include big-box retailers. Furthermore, net lease REITs enjoy the ownership of freestanding properties, wherein both rent and majority of operating expenses for the properties are borne by tenants.

What’s Shaping Future of the REIT and Equity Trust - Retail Industry?

Store Closures, Retailer Bankruptcies Hurting Demand: Mall traffic continues to suffer with e-commerce capturing market share from the brick-and-mortar stores, and heightening store closures and retailer bankruptcies. This has raised concerns over the fate of cash flows of physical stores and landlords as the trend is considerably curtailing demand for the retail real estate space. Also, there is likely to be no respite in the near term as the choppy environment might prevail, with dwindling footfall at retail properties amid social-distancing measures and higher e-commerce adoption due to the coronavirus crisis. Rightsizing of stores and retailer bankruptcies will likely prevail even with an economic recovery. Particularly, several store closures and bankruptcies will result from structurally weakening categories’ inability to battle the pandemic blues.

Declining Rents, High Concessions and Collection Woes to Prevail: The current business model and economics will no longer be able to support the pre-pandemic rent levels for a number of businesses. In fact, amid high vacancy, lease transactions in the near term will likely be driven by declining rental rates, concessions as well as protections related to pandemic. Further, rent collection and deferral issues are likely to be more pronounced for landlords having exposure to non-essential retail tenants. Malls and urban-core retail assets have been battered the most with occupancy declines and rent slides. As such, rent negotiations and lease restructuring pertaining to COVID will prevail in the upcoming period.

Structural Changes, Omni-Channel Strategy to Continue: Retail REITs will continue with the transformation measures. While earlier the emphasis was on transforming traditional retail hubs into entertainment destinations and lifestyle resorts, the focus has now shifted more toward essential retail like groceries, convenience stores and others, and curbside pick-ups in light of the pandemic. Omni-channel will keep being the focal point for retailers and digitally-native brands are likely to keep boosting their presence. Also, implementation of innovative touchless technology on everything from entrances to order fulfilment will gain traction and provide a competitive edge. Apart from automotive showrooms, health and service centers too are likely to capitalize on market-dislocation opportunities.

Repurposing and Conversions to Pick Up Pace: Importantly, the current situation is prompting the adaptive reuse as well as conversions of malls into distribution hubs as these distribution centers, being situated close to the consumers of retailers, facilitate faster delivery of products as well as aid retailers in improving services, lower costs and make optimum asset utilization. Adaptive reuse is also including multifamily, office and medical components. However, the structural changes involve huge outlay, and with continuation of rent collection and deferral woes, profit margins are likely to be affected in the near term.

Reopening of Stores and Vaccine Development Raise Hopes: Nevertheless, the reopening of the retail sector in several parts of the United States has come as a relief. This is because, with more reopening of stores, tenants stand in a better position to generate revenues and make their rent payments. Thus, the pressure on retail landlords is likely to reduce and their rent-collection figures are expected to improve. Specifically, retail properties having more exposure to essential retail businesses are well poised to yield better cash flows. Also, positive development on the COVID-19 vaccine front is likely to raise hopes for this industry. In addition, though e-commerce growth massively picked up pace in the current year, this growth rate is likely to stabilize in the upcoming period and the brick-and-mortar stores will regain their popularity in delivering physical experiences apart from becoming valuable in the fulfillment of digital sales. Nonetheless, the ones with better balance-sheet strength are likely to navigate smoothly through the coronavirus blues.

Zacks Industry Rank Indicates Bleak Prospects

The Zacks REIT and Equity Trust - Retail industry is housed within the broader Zacks Finance sector. It carries a Zacks Industry Rank #241, which places it at the bottom 3% of more than 250 Zacks industries.

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates bleak near-term prospects. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

The industry’s positioning in the bottom 50% of the Zacks-ranked industries is a result of the negative funds from operations (FFO) per share outlook for the constituent companies in aggregate. Looking at the aggregate FFO per share estimate revisions, it appears that analysts are losing confidence in this group’s growth potential. Over the past year, the industry’s FFO per share estimate for 2020 and 2021 moved 21.7% and 8.7% south, respectively.

Before we present a few stocks that you may want to consider for your portfolio, let’s take a look at the industry’s recent stock-market performance and valuation picture.

Industry Lags on Stock Market Performance

The REIT and Equity Trust - Retail Industry has underperformed the broader Zacks Finance sector, as well as the S&P 500 composite in a year’s time.

The industry has declined 15.9% during this period compared with the S&P 500’s rally of 15.9%. During the same time frame, the broader Finance sector has lost 5.9%.

One-Year Price Performance

Industry’s Current Valuation

On the basis of forward 12-month price-to-FFO (funds from operations) ratio, which is a commonly used multiple for valuing Retail REITs, we see that the industry is currently trading at 15.22X compared with the S&P 500’s forward 12-month price-to-earnings (P/E) of 22.51X. Moreover, the industry is trading below the Finance sector’s forward 12-month P/E of 17.15X. This is shown in the chart below.

Forward 12 Month Price-to-FFO (P/FFO) Ratio

Over the last five years, the industry has traded as high as 19.44X, as low as 9.72X, with a median of 14.66X.

3 Retail REIT Stocks Trying To Survive The Industry Challenges

Realty Income Corporation: The REIT is engaged in the acquisition and management of freestanding commercial properties that generate rental revenues under long-term net lease agreements. High dependence on tenants belonging to service, non-discretionary and low-price retail businesses, which are less susceptible to economic recessions and competition from Internet retailing, provide stable rental revenues. Also, with its top tenants selling essential goods and a strong balance-sheet position, the company seems well poised to sail through the current turbulence. Management also raised the 2020 acquisition guidance to $2 billion on the company’s robust financial position and continued performance of its business. Along with its well-known commercial tenants, investors might love the fact that the firm pays a monthly dividend.

Realty Income currently carries a Zacks Rank #3 (Hold). The Zacks Consensus Estimate for the 2020 and 2021 FFO per share moved marginally north to $3.38 and $3.48 over the past two months, reflecting positive sentiments. The figures suggest an increase of 1.8% and 2.9% year on year, respectively. The company’s shares have rallied 23.1% over the past six months.

Agree Realty Corporation: This retail REIT is based in Bloomfield Hills, MI, and is into acquisition and development of properties net leased to industry-leading retail tenants in e-commerce and recession resistant sectors. The Zacks #3 Ranked company has received 99%, 99%, 97% and 96% of October, September, August and July rent payments, respectively. Furthermore, backed by its decent year-to-date investment volume and robust pipeline, the company has raised the current-year acquisition guidance to $1.25-$1.35 billion.

The Zacks Consensus Estimate for this year’s FFO per share has remained unchanged at $3.18, while the same for 2021 has been revised nearly 1% upward over the past 30 days to $3.42, indicating a year-on-year improvement of 3.3% and 7.6%, respectively. The stock has appreciated 12.2% over the past six months.

Retail Opportunity Investments Corp.: This REIT specializes in the acquisition, ownership and management of grocery-anchored shopping centers situated in densely populated, metropolitan markets across the West Coast. Focus on essential retail tenants has been helping this REIT, which achieved double-digit rent growth on both new leases signed and renewals during the third quarter. It currently carries a Zacks Rank of 3.

Over the past month, the Zacks Consensus Estimate for FFO per share for 2020 and 2021 witnessed upward revisions of 4% and 2%, respectively. The stock has also rallied 41.5% over the past six months.

Note: Funds from operations (FFO) is a widely used metric to gauge the performance of REITs rather than net income as it indicates cash flow from their operations. FFO is obtained after adding depreciation and amortization to earnings and subtracting the gains on sales.