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As fears of the fiscal cliff subside, the REIT market continues to appreciate. It is approaching the historically high levels preceding the Great Recession.


(Click to enlarge)

While REITs earnings have also been strong, price appreciation has outpaced legitimate growth and REITs have become overvalued. An average price to FFO of 15.77 for U.S. Equity REITs really limits the earnings return on investment for the general REIT investor. However, if we look at individual securities, many opportunities remain which have a strong chance to outperform the market. Presented below is my personal diversified REIT portfolio.

Company (ticker)

Recent Market Price $

Price/2013 estimated FFO*

Yield %

Ashford Hospitality Trust (NYSE:AHT)

$10.87

6.47

4.07%

Associated Estates (NYSE:AEC)

$16.37

12.13

4.63%

CapLease (NYSE:LSE)

$5.61

9.35

5.35%

CorEnergy Infrastructure Trust (NYSE:CORR)

$6.02

Anywhere from 4 to 10**

8.31%

Gladstone Commercial (NASDAQ:GOOD)

$18.27

10.94

8.17%

Inland Real Estate (NYSE:IRC)

$8.53

9.27

6.68%

Northstar Realty Finance (NYSE:NRF)

$7.22

6.56

9.38%

Omega Healthcare Investors (NYSE:OHI)

$24.23

10.91

7.26%

Supertel Hospitality (NASDAQ:SPPR)

$1.03

7.36

0%

Whitestone REIT (NYSE:WSR)

$14.31

12.89

7.99%

Portfolio unweighted average

n/a

9.29

6.28%

SNL U.S. Equity REIT avg.

n/a

15.77

4.21%

*Consensus estimations by FactSet

** Consensus estimate has not been updated to reflect a massive acquisition, so I have given a broad range within which it will likely fall.

In addition to the common equity, I have the following preferreds:

  • Ashford Preferred D (AHT-D)
  • Northstar Preferred B (NRF-B)
  • FelCor Lodging Trust (NYSE:FCH) preferred C (FCH-C)

This portfolio is designed to fit my needs and is certainly not for everyone. It includes some calculated risks that may not be suitable for a less risk-tolerant investor. It is not designed for buy and hold as it requires constant research and reallocation.

Below we will discuss the catalysts for outperformance, the balance of the portfolio, and the importance of each security within it.

Catalysts for outperformance

The catalysts are threefold:

1) Tangible valuation: With an average price to estimated FFO of 9.29 as compared to the U.S. Equity REITs average of 15.77, the portfolio is designed to provide superior earnings return on investment. These low valuations are projected to generate 70% more earnings than the average REIT. Over time, these earnings have a tendency to translate to returns, whether it be by distribution or through price appreciation. Of course, analyst estimates will only go so far, so I have filtered the stocks for those that should meet or exceed the estimates. This leads us to catalyst # 2.

2) Intangible valuation: Many of the aforementioned companies participate in cyclical industries and are on the upswing of their respective cycles. Thorough examination reveals that management of most of these securities has a superb level of expertise. I believe strong decision making by the company leaders combined with the upswing of their cycles gives these companies a solid chance to meet or exceed consensus earnings estimates.

3) No waste: Every position in my portfolio has the potential to individually outperform the market. I believe many portfolio managers diminish their returns through excessive hedging with puts/options or true hedges such as short positions to cover long ones of a similar nature. Safety is certainly desirable, but in my opinion there is a better way to achieve it: diversification.

This brings us to our next section.

Portfolio balance

Certain REIT sectors have a deep structural strength that will drive earnings over the next few quarters. I balance this against relative cost to determine weight.

  • Multi-family - Occupancy and rates are already high, yet projected to continue climbing through 2013. This strength is balanced out by the heavy pricing of these stocks, so I put normal weight in this sector.
  • Retail - Consumer confidence is rising and unemployment declining creating some healthy demand, but an incredibly low barrier-to-entry makes oversupply an issue. The fairly cheap prices of many securities in this sector justify normal weight.
  • Industrial - A revival of domestic manufacturing is poised to cure the weak leasing rates perpetuated by the oversupply going into the Great Recession. Anticipation of such an event has led the market to price these securities at an average P/FFO over 16. Thus, I underweight this sector.
  • Office - The downturn in rates and occupancy may appear to be cyclical, but I believe it's a deeper problem. Technology has made office workers exponentially more efficient, so jobs which used to require a squad of workers can now be performed by 1 person with a spreadsheet. Working remotely is also becoming increasingly viable. Companies are innovating ways to run more efficiently and cutting back on office space is one of the easier ways to do so. I underweight this sector.
  • Healthcare - The untapped sale leaseback market led to incredibly high acquisition cap rates around 8%-11%. Strong and growing triple-net earnings make this sector quite promising. I formerly overweighted it, but since the steep price incline, I have sold down to a normal weighting.
  • Hotels - Although frowned upon by much of the market for its fluctuating earnings, this sector has a very promising outlook. On top of the sturdy RevPAR growth of 2012, continued gains are projected throughout 2013. Furthermore, much of it should come from enhanced ADRs which will expand profit margins. Despite such a strong outlook, the hotel sector trades at the lowest average earnings multiple of any REIT sector (12.5 as of 12/28/12). I overweight this sector.
  • Diversified REITs - As these vary greatly in terms of operations, there is little reason to place a weight on the sector. Select companies within it, however, present excellent opportunities.

Each security and why I like it

As my portfolio presently consists of 10 different companies, each with unique operations, a full description would be tedious. For efficiency, I will provide the most pertinent information for each one below. If any of these companies seem intriguing, you may access full focus articles on each one in my archived articles.

Ashford Hospitality Trust

Hotels are positioned to succeed, and AHT is the best value amongst them. Despite nearly 50% price appreciation, it remains a cheap play on domestic upper-upscale hotels. Recent refinancing has significantly reduced its cost of capital thereby increasing its already solid AFFO. Time and time again, Montgomery Bennett has proven himself to be a superb CEO.

  • Massive share buyback during previous recession at extremely cheap prices.
  • Maintaining a large stockpile of cash for protection from the next downturn.
  • Cleanly times the companies leverage to be highly levered during economic upswings to maximize gains, and reduces leverage in preparation for recessions to minimize damage.
  • Keeps nearly all debt non-recourse which AHT has used successfully to cut off underwater properties with little damage to the overall company.

The preferred D is quite safe from redemption as the company has more pressing debt obligations and would elect to redeem the higher coupon Series A first.

Associated Estates

AEC is the strongest value among multi-family REITs. It is set apart from the competition by the youth and quality of its portfolio which allows it to charge higher rates.

  • Has been able to dispose off older assets at fairly low cap rates.
  • Produces excellent NOI growth at an average rate of 3.8% since 2004.
  • Trades at a deep discount to its consensus NAV of $19.05.

CapLease

Triple-net lease REITs are beloved of shareholders for the extremely steady returns. This has led to many of them becoming overvalued. CapLease got left in the dust as the investment community believed it to be too levered. Despite material debt reduction to what is now a safe and clean balance sheet, the price has only risen slightly. An investment in LSE provides long duration contractual earnings for an irrationally cheap price.

CorEnergy Infrastructure

It may seem strange to include this former BDC in my REIT portfolio, but it is approaching a REIT conversion. All conditions for conversion to a REIT have been met with exception to getting at least 75% of its earnings from REIT qualifying assets. It stands only a few basis points off and should have no trouble meeting the goal through selling a portion of its securities portfolio or making an additional REIT acquisition. We can expect smooth and steady earnings as the majority will come through a 15-year lease with inflation escalation.

  • Previously traded around $9.00 but currently available at $6.00.
  • REIT conversions historically come with an immediate price bump.

Gladstone Commercial

GOOD consists of a conglomerate of triple-net leased properties with so much variety that they can only be categorized through the method in which they were acquired. David Gladstone continually scours every viable market for opportunistic acquisition. Thus far, his efforts have been successful resulting in continuous AFFO growth. However, this position may not remain in my portfolio for long. It is approaching full valuation and has a couple of aspects that trouble me.

1) Acquisition cap rates across all sectors are becoming smaller, but GOOD continues to buy. This could dilute its presently superb property portfolio.

2) FFO payout over the past 5 years has been in the high-90s. While the yield is enormous, it seems unlikely to grow in the near term.

Inland Real Estate

IRC is a fairly standard shopping center REIT but is set apart from the competition in two major ways.

1) Its cheap valuation does not come with extra risk or weak performance. It is surprisingly comparable to its larger and more established comps, but can be had for less.

2) IRC puts effort into protecting the longevity of its shopping centers by making sure to have a strong traffic driving anchor. In the past, even when dark anchors were staying current on rent payments, IRC chose to replace them. This preserves the property value and prevents rental roll-down on lease expiry.

Northstar Realty Finance

NRF was not as hurt operationally by quantitative easing as were the agency mREITs. Its diligence in only purchasing at a discount removes the threat from prepayment. NRF's greatest earnings boost came from the repurchase of its own CDOs at pennies on the dollar. Unlike most other mREITs which are being forced to scale back dividends, NRF's operational performance affords increasing distribution. That being said, the market price of NRF has risen dramatically to reflect all this well-being, so it may also be sold from my portfolio soon.

The NRF preferred, however, is here to stay. It trades well below liquidation value and represents a sustainable large dividend.

Omega Healthcare Investors

As previously mentioned, the healthcare REIT sector is booming, but also becoming pricey. OHI appreciated nicely along with the sector, but stellar earnings have kept its P/FFO reasonably low. At 10.91, it represents the best value and its long-term leases on its portfolio of SNFs suggest stability. Recession-resistant demand makes OHI a great choice to hedge tail risk without losing performance in times of economic strength.

Supertel Hospitality

SPPR got demolished by the Great Recession and has since recovered. Numerous dispositions of economy class hotels facilitated cleaning up of its balance sheet and began the work toward a portfolio of the more prosperous midscale hotels. Upon recovery, Supertel gained the bargaining power to refinance much of its debt and significantly reduce its cost of capital. It was this step that brought it to profitability.

Going forward, even a slight boost to RevPAR would raise earnings beyond the point justifiable by the $1.02 price. So far economy class hotels have not seen the prosperity of higher class hotels, but I believe the environment for such an event is emerging.

Whitestone REIT

WSR has a well-networked acquisition team that specializes in picking up distressed properties off the market. Every property in Whitestone's portfolio was acquired below replacement cost and at high cap rates. With caution taken to ensure the properties were in highly visible and highly trafficked areas, there is a large upside to leasing going forward. Previously, there was some concern as the oversized dividend was not covered by FFO, but the recent acquisitions have pushed earnings to a sufficient level.

Conclusion

I trade with high frequency, so these positions are not intended to be buy and hold. While the portfolio may change, the principles behind it remain constant. Trading with fundamentals on your side gives a better chance for outperformance.

Source: My 2013 Diversified REIT Portfolio Designed For Outperformance