A Troika of REITs: Creating Higher Income in a Depressed Market 12 comments
Glenn Cutler
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Falling interest rates have hurt savers. People in retirement and those who are close to retirement have seen their income from savings and investment decline significantly as interest rates worked toward the zero line. The broad based economic weakness in tangent with the deterioration in the credit markets have brought economically sensitive assets down in value. Therein rests the opportunity to take advantage of lower prices to potentially generate higher income through dividend yields.
One of the hardest hit sectors in the financial markets has been debt financed companies. This includes the REITs or Real Estate Investment Trusts. These companies are required by law to pay out 90% of their earnings to qualify as a REIT. The Internal Revenue Code lists the conditions a company must meet to qualify as a REIT. For example, the company must pay 90% of its taxable income to shareholders every year. It must also invest at least 75% of its total assets in real estate and generate 75% or more of its gross income from investments in or mortgages on real property.
Each of these companies maintains an investment portfolio of properties which generate income through leasing and renting out space. Some focus on commercial properties, others on residential. REIT portfolio strategies vary. Some focus exclusively on office complexes while others emphasize shopping centers and malls. Still others focus on residential property or condominiums and operate mostly in the mortgage market. With the economy trending lower, the primary concerns of investors are the ability of a REIT to maintain high occupancy rates as well as their ability to refinance short-term debt obligations, particularly in this tight credit market environment.
Most REITs have seen their stock prices driven down to levels not seen in a decade. With high profile retail chains filing for bankruptcy like Circuit City and Linens and Things to name two, REITs are faced with the challenge of releasing their empty space when they lose a steady paying long-term client. Still, there are many REITs that are probably more durable than their stock prices currently reflect, thus creating an opportunity to upgrade income in our investment portfolios as well as creating the possibility for significant capital appreciation when the economy eventually recovers and stock prices go back to reflecting cash flow and the value of underlying assets.
Here is an investment idea for a small, diversified basket of 3 REIT stocks: PEI, MSW, and HRP.
REITs - LOOKING DANGER SQUARELY IN THE EYE - A TROIKA
When fear is highest is usually a great time to upgrade income and strengthen investment portfolios. The problem is when it comes to REITs - how do we know which ones are vulnerable to dividend cuts and the more problematic concern of debt refinance challenges? Certainly, some of that can be accomplished through research. Some of the downside risk has already been discounted by the fear that is already reflected in the stocks.... so if a REIT stock is yielding 30% you figure the dividend might get cut, but the shares may actually improve and the remaining yield will still be good.
With the cautionary “Buyer Beware” – here’s a diversified troika of 3 REIT stocks (ticker symbol, div yield) that have nice yields that appear to be in stronger positions than most in terms of their scheduled debt maturities, their balance sheet strength, their ability to finance, the strength of their occupancy rates and the experience of their management teams – Pennsylvania Real Estate Investment Trust (PEI, 30%), Mission West Properties (MSW, 11%) and HRPT Properties Trust (HRP, 24%).
Pennsylvania Real Estate Investment Trust (PEI) based in Philadelphia, PA was founded in 1960 and is one of the oldest equity REITs in the United States. Its portfolio of properties focuses on retail shopping malls and power centers. It has over 34 million square feet from 56 properties including 38 shopping malls, 14 strip and power centers and 4 properties under development. Most properties are located in the Mid-Atlantic region.
With a slow economy and so many retailers going out of business this would seem like a risky investment right now. Conversely, we think most REITs offer a unique characteristic of high total returns from capital gains and dividend income given the thrashing this sector has taken. However, selectivity is important and there are several reasons why we have confidence in this one. This company has never missed or reduced a quarterly cash dividend, making the latest payout the Company's 127th consecutive distribution since its initial dividend paid in August of 1962. That means management has guided investors through several up and down economic cycles, a checkmark for experience.
We also note that despite incredibly tight credit markets it has been able to finance its needs uninterrupted, including recent news of $173 million in non-recourse mortgage loans, giving it an aggregate for the year of $820 million in financings.
Another confidence booster has been the steady flow and increasing size of open market stock purchases by key insiders. Since mid-August there has been a steady stream of purchases in the $19-$20 range that increased commensurate with the fall in the shares price. This insider transactions link will lead you to this list which includes a $1.4 million purchase by a director at $7.28, another $600,000 buy from the same person a week later at $6.11 and a $970,000 buy from the chairman and CEO on Dec 17 at $6.47. Obviously, the share price is factoring in some kind of dividend cut, but if the company continues to pay out at the rate of .57 per share quarterly, the return will be 29% and in less than 4 years you would have your entire investment back from dividend income. Gains from the stock price would be gravy. There are many attractive REITs out there now but this one inspires higher confidence and an acceptable risk/reward ratio.
MISSION WEST PROPERTIES (MSW) based in Cupertino, CA was founded in 1969. It operates as a self-managed, self-administered and fully integrated engaged in managing, leasing, marketing, development and acquisition of commercial R&D properties, primarily located in the Silicon Valley portion of the San Francisco Bay Area. The Company manages 111 properties totaling approximately 8.0 million rentable square feet, which includes approximately 854,000 rentable square feet (16 buildings) that are in the process of being rezoned for residential development. In November the company announced authorization of a $5 million stock repurchase program.
Despite tough market conditions, especially in California, the company recently sold 2 properties for $65 million which netted $16.9 million in cash and a significant one-time gain using equity accounting. Given the rough market conditions the company also updated information on its own financial situation citing confidence in their market position and capital strength. It indicated that its balance sheet is one of the strongest in the industry and listed a series of debt and coverage rations that clearly reflect its ability to be flexible to take advantage of market opportunities and continue its annual dividend policy. Of particular note is that the company has no mortgage debt maturities until 2013 and have no unfunded development commitments.
Since July there have been 6 insider stock purchases totaling 61,000 shares by officers and directors and no sales. The opportunity to earn over 10% in dividend income with potential capital appreciation gives this REIT a favorable risk/reward profile.
HRPT PROPERTIES (HRP) based in Newton, MA, was founded in 1986. As of September 30, 2008, it owned $6.1 billion of office and industrial properties through 533 properties with approximately 66 million square feet located in 37 states and Washington, D.C. The company employs a defensive strategy by focusing on client prospects in the medical sector and government agencies. It also tends toward longer leases that typically results in higher rates of renewal.
During the recent quarter, transaction activity remained brisk with the purchase of 44 office and industrial properties and the sale of 23 properties which resulted in a net increase of nearly 2 million square feet. There is no near-term debt maturity, though in 2010 it will have the $750 revolving credit facility coming due, which it has a 1-year option to extend. The stock price certainly indicates some worry about a possible dividend reduction. However its FFO has been more than ample to cover recent dividend obligations and its diverse portfolio and conservative strategy provides some insulation in a tough economy. At the current price, shares are discounting a certain amount of risk already.
Disclosure: CSSR has an equity position in HRP. There are no equity positions held in the other stocks mentioned in the report.
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This article has 12 comments:
Let me mention only the Russian housing market. Our marketing research real estate market showed that house prices in the second half of 2008 fell by 40%.
In fact, latest reports for retail store closings are horrific. Some expect an additional 200,000 store closings in 2009 and 2-3,000 mall closures. The office market isn't looking any brighter with unemployment rising which has shown to have a direct correlation to office space occupancy.
Adding to all of this, and to any of these above REITs, the new IRS temporary guidance for REITs issued on Dec. 10th that allows them to issue stock in lieu of cash for their dividends until Dec. 2009. You will not be able to bank any cash parking money there and the risk going forward for commercial real estate is substantial.
finance.google.com/fin...
And, of course, I can't help but notice that you neglected the rest of my argument. Don't you think major tenant loses will result in a declining cash flow...eh? Don't you also think that they might easily utilize the stock versus cash IRS provision for dividends in order to conserve cash given forward projections of greater losses?
On Jan 04 05:27 PM 22thoroughbred wrote:
> REITs don't trade on earnings they trade on cash flow, they can lose
> money IF they have the cashflow to pay the dividend, not that I have
> looked at any of these 3, but at least know the sector before you
> slam an idea
1. The market cap is $280M with an EV of $2.8B. That's a 10% equity slice. If you see the property values go down more than 10%, the equity is essentially toast. Yes, they can retain capital. All you're telling me is the stock will go lower until they can retain enough capital to build up actual equity value again and pay a dividend. There's a little less of a point in owning a REIT if there's no dividend.
2. A number of Real Estate insiders are terrified there's a collapse coming in the commercial market in New York. I can't speak to the rest of the country, but they've already initiated discussions with their lenders to head off the eventuality that they're running afoul of their covenants even at 40% LTV. The problem is that the guys that are levered at 80-90% LTV (PEI would be in this group) are going to fail and disgorge millions of sqft into the market. This will push asset values down significantly, regardless of leverage levels.
they can move up to a 10 percent yield with only a slight easing in the markets, with an effective 40 percent return per annum over the next 2 years.
3 days after your post, they dropped the div in half.