Emergent Mispricing From The Indiscriminate REIT Sell-Off

 |  Includes: AGNC, DLR, NNN, O, VTR
by: Dane Bowler

REITs have gotten destroyed these past couple of months with the broader markets outperforming them by around 2000 basis points. As evidence, one need look no further than a chart of the REIT index (^RMZ) compared to the S&P, Dow and Nasdaq.

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Interestingly, REITs have tumbled across the board with seemingly no regard to sector or fundamentals. While some of the stocks warranted a price correction, others have become irrationally cheap. This article will highlight the most prominent cases of each category. We will begin with the stocks that should have fallen and finish with the screaming opportunities.

Proper Price Corrections

When I call the corrections in these stocks "proper" I am not suggesting that these are bad companies. Instead, I only mean that the price drop was fundamentally justified and that the lower price more accurately reflects the true value of a share. Among REITs, 3 drops stick out as being particularly justifiable: National Retail Properties (NYSE:NNN), Realty Income (NYSE:O) and American Capital Agency (NASDAQ:AGNC).

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Let us review each in more detail.

National Retail Properties fell over 17% since the REIT sell-off began, yet it remains a fairly pricey equity at 18.3X FFO. Realty Income has a similar story, dropping 22% and retaining an 18X trading multiple. I believe the reasoning behind each sell-off is the same, so we will review these together.

Over the past couple years, retirees and others who invest as a primary source of income were driven out of the bond market in search of sufficient yield. NNN and O stood as the beneficiaries of this flight as they are as close to being a bond alternative while providing sufficiently high yield as one can find. The long-term, investment grade and triple net nature of their revenue streams suggests incredible stability of earnings and consequently struck yield seekers as excellent investments. The favorable environment for NNN and O drove their prices beyond 22X forward FFO and their yields each approached 4%.

Justification of the price drop

The price drop was merely an undoing of the bloat created by the favorable environment. Since the hinted tapering of QE, 10 year treasuries have risen to around 2.6%. In the presence of a 2.6% "risk free" yield, 4% yield from an equity no longer seems like a desirable risk adjusted return. The market price had to adjust to bring the risk reward ratio back in line. Hence the correction.

As it stands today, NNN and O have dividend yields of 4.68% and 5.05% respectively. Given their high FFO payout ratios, the dividend makes up a vast majority of expected returns. As higher pricing would make these investments undesirable relative to other yield investments in this slightly less low yield environment, I strongly believe that the price drop was justified and that it will persist.

The triple net REITs are tied to interest rates on a comparative basis; they become more desirable as fixed income investments became less desirable and vice versa. AGNC, however, is tied to interest rates on a more fundamental level. As a highly levered and extremely high yield investment, AGNC was never really a bond alternative and its rise and fall has a very different story than the triple net REITs. Rather than becoming less desirable on a comparative basis in the new interest rate environment, AGNC has become less desirable on an absolute basis.

Volatile and rising interest rates have substantially reduced AGNC's book value 2 quarters in a row and continue to pose a threat. AGNC was even forced to reduce its dividend.

Justification of the AGNC correction

Since the REIT sell-off began, American Capital Agency dropped 23%. I believe that such a drop is reflective of the actual fundamental harm sustained by the company and places it at fair value going forward. Between a 12% drop in book value from $28.93 to $25.51 and a dividend cut to $4.20/share from $5.0/share annually, the 23% drop in market price makes it only a slightly better value than it was before. In my opinion, the slightly higher implied cap rate of the present market pricing is warranted to balance out the increased environmental uncertainty.

In all 3 of the above cases, the correction has worked to bring the market prices closer to intrinsic values. Unfortunately, properly priced stocks present little opportunity so there is little upside to be found going long or short the aforementioned stocks. However, the REIT sell-off also brought substantial mispricing. Specifically, market prices of fundamentally thriving companies were dragged down with the rest. Herein lay the opportunities.

Strong and Undervalued

Digital Realty Trust (NYSE:DLR) and Ventas (NYSE:VTR) dropped 15% and 22% since the REIT sell-off began.

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Amazingly, these sold down during a period of superb fundamental performance. We begin with DLR.

DLR is a data center giant with an impressive international portfolio collecting contracted leasing revenue. Its primary concern has been lease renewal as there has been speculation of rent roll-downs. Much of this concern was alleviated by the 2Q earnings release which detailed leasing activity:

"Leasing Activity: Since the end of the first quarter, the Company signed leases totaling $35.6 million in annualized GAAP rental revenue, which includes over $16.0 million in annualized GAAP rental revenue of new lease signings in the second quarter of 2013 and an additional $19.5 million in annualized GAAP rental revenue of new lease signings in July.

Of the total leases signed during the second quarter of 2013, 111,000 square feet was for space located in the Company's North American portfolio. This includes 50,000 square feet of Turn-Key FlexSM space leased at an average annual GAAP rental rate of $209.00 per square foot, nearly 39,000 square feet of Powered Base Building® space leased at an average annual GAAP rental rate of $23.00 per square foot, over 8,000 square feet of colocation space leased at an average annual GAAP rental rate of $223.00 per square foot, and nearly 14,000 square feet of non-technical space leased at an average annual GAAP rental rate of $24.00 per square foot.

Leases signed during the second quarter of 2013 for space in the Company's European portfolio totaled over 4,000 square feet of Turn-Key Flex space leased at an average annual GAAP rental rate of $188.00 per square foot.

Leases signed during the second quarter of 2013 for space in the Company's Asia Pacific portfolio totaled over 7,000 square feet of Turn-Key Flex space leased at an average annual GAAP rental rate of $223.00 per square foot, and over 1,000 square feet of non-technical space leased at an average annual GAAP rental rate of $71.00 per square foot.

For the quarter ended June 30, 2013, the Company commenced leases totaling nearly $24.6 million of annualized GAAP rental revenue, including over $1.6 million of colocation revenue."

In addition to silencing leasing fears, this report came with upped guidance with 2013 FFO now expected to come in at $4.73-$4.82. Between improved earnings and a substantially reduced market price, DLR can be had at only 11.3X forward FFO. In my opinion, it is underpriced and represents substantial opportunity.

Ventas is a similar opportunity in that it also upped 2013 guidance in the face of the sell-off. New guidance of $4.06-$4.10 is reflective of a reduced weighted average cost of capital and improved NOI in its 3 largest segments; senior housing, triple net and MOB.

On the surface, a reduced weighted average cost of capital looks good, but let us dig deeper to understand just how much it will benefit VTR in the long run. Their cost basis was reduced through the issuance of low fixed rate long duration senior notes. As an example, VTR issued $500mm of 2.7% notes due 2020. Locking in such low rates is ideal as it protects VTR from interest rate risk.

It seems almost absurd that one of the primary drivers of the sell-off of VTR was rising interest rate speculation when it is among the most protected from interest rates. Ventas has superb access to capital markets and intelligently utilized this access to lock-in cheap financing for the long run.

Both sides of VTR's balance sheet have been improved and its portfolio is performing superbly on a fundamental level, yet the market priced dropped 22%. This is a rare opportunity to pick up a true blue- chip healthcare REIT at only 15.9X forward FFO.


The REIT sell-off was almost universal with little discretion between performing and non-performing companies. Analysis of the fundamentals distinguishes between those that should have dropped off and those that have become opportunities. Digital Realty Trust and Ventas stand out as strong buys in the current pricing environment.

Disclosure: I am long VTR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. 2nd Market Capital and its affiliated accounts are long VTR. This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer.