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Yesterday Dane Bowler wrote an excellent article that provided a strong argument that REITs are sound and that investors should "look at the fundamentals and take advantage of the temporary discounts." Bowler voiced his bullish sentiment by adding that it may be a "good time to increase allocations to this fine asset class."

Bowler made a good point in the same article as he explained that the Triple Net REITs have "locked in revenue streams" and although the long-term leases are "beneficial as it improves the security of earnings," the bond-like characteristics are also a "primary reason for the (recent) sell-off." Bowler went on to explain:

The speculated rising interest rate environment should afford higher rental rates. Given that the triple net REITs such as American Realty Capital Properties (NASDAQ:ARCP) are locked in for so long, they will be unable to capitalize on the ability to charge tenants more. This portfolio balances ARCP with 2 companies that can fully take advantage of the potentially rising rental rates; Ashford Hospitality Trust (NYSE:AHT) and Associated Estates Realty Corp. (NYSE:AEC).

I agree with most of Bowler's theory (as outlined above) and I also like his choice of Ventas, Inc. (NYSE:VTR), a moderately valued "blue chip" REIT that has evolved into a consistently durable brand. In my latest newsletter, I featured Ventas (as a "blue chip") and Bowler and I reached the same conclusion that the premium brand is "delivering something special"; however, I believe the shares (trading at $68.04) are less attractive due to such a modest dividend yield of 3.94% (the lowest dividend in the health care sector).

How Can Rising Rates Impact REIT Valuation?

It's no secret that the impact of rising interest rates on REIT performance impacts valuation. In one way, higher interest rates reflect higher cost of capital. However, it also reflects an improving economy and growth prospects with the potential to improve market rental rates and occupancy.

Obviously, rising interest rates will eventually impact REIT cash flows by changing debt refinancing rates. It will also impact REIT valuations by increasing the required returns. For some REITs, this higher rate of return will be offset by higher cash flows over time as they increase rate and occupancy.

In this article, I thought it would be interesting to take a look at the valuations of several Triple Net REITs - namely Realty Income (NYSE:O) and American Realty Capital Properties - both known for long-term lease attributes and another of my SWAN (sleep well at night) REITs, Healthcare Trust of America (NYSE:HTA). The purpose for the comparison is to illustrate how the two forces - cash flow and valuation - are at work together.

In the first example, I modeled out a very simple estimate of Realty Income's dividend income stream - growing at low 1.5% per year over 10 years, regardless of interest rate. Then (as illustrated below) I changed the cost of capital to reflect the net present value (or NPV) of the cash flows, a good estimate of proper stock valuation. As you can see, I currently show that Realty Income's cash flows are being discounted at a 6.25% ($41.89 per share). If this rate increases to just 7.0%, the value of Realty Income's cash flows falls to just over $36. Again, as a Triple Net REIT, Realty Income has limited ability to grow any faster than their low fixed rent bumps.

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Now similarly, I put together the same data for ARCP. Note that using the same simple 1.5% growth assumption and using an 8% discount rate, I arrive at today's stock price of $14.22. However, ARCP has entirely floating rate debt currently and a number of looming transactions to close (including CapLease and ARCT, both mentioned in a recent article).

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On the other hand (and as pointed out in Bowler's article) an improving economy will help Healthcare Trust of America grow its cash flows. As a result, I put together two scenarios that show the current low growth cash flows and one that reflects an improved economy. I then did the same NPV test to come up with a valuation for HTA. In my first scenario - using a 6.25% cost of capital - I come up with a value of $12 per share. In the higher interest rate forecast, I increased the annual growth rate in addition to the discount rate to 7.25%. Interestingly, the valuation in the second scenario actually increases to $12.55 per share.

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The only investors who shouldn't diversify are those who are right 100% of the time (Sir John Templeton)

In both my SALSA and SWAN portfolios, I have a diversified exposure with healthcare and triple-net REITs. I often allocate a reasonable percentage of Triple Net REITs because I believe that they provide the most stable and consistent dividends. However, the growth is limited by (1) the contractual long-term leases, and (2) the high occupancy levels (with limited internal growth). Conversely, the healthcare REITs enjoy shorter-term leases that allow higher growth and they also have room to grow internally by leasing up vacant space.

My sleep well at night ("SWAN") portfolio is designed for modest diversification (like Buffett) and I have over-weighted the REIT sectors with a highly defensive concentration of triple-net, healthcare, and industrial REITs. Even in a rising interest rate environment, I remain a bullish proponent of the Triple Net sector as I believe the sustainability fundamentals (i.e. contractually long-term leases) provide for an attractively well-balanced value proposition: stable dividends and moderate growth. However, to be properly diversified across geographic and property types, an intelligent investor should gain diversified exposure to commercial real estate mandated by the full spectrum of structured options - a tried and true formula for sleeping well at night.

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Source: SNL Financial

For Research Only: This article is intended to provide information to interested parties. As I have no knowledge of individual circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended.

Source: An Intelligent Perspective On Rising Rates And REITs