3 Small Cap REITs With Upside Potential

Includes: FUR, OLP, ROIC
by: Jake Huneycutt

We are now passing the second anniversary of one of the greatest buying opportunities in decades. It was back during this time frame, March 2009, that I began an absolute REIT-buying binge. I knew very little about the sector at the time, aside from the fact that most of the companies had such a huge margin of safety that it didn’t even matter if my numbers were slightly off. It was really tough to lose in that environment, so long as you had some conviction.

In spite of this, most of the analysts were bearish. Not only did many investors believe REITs were dead money; many went a step further and claimed that the REIT business model was unsustainable and that half of them would be bankrupt within a few years. ZeroHedge, a publication that had spent several months berating REITs, even recommended that people buy into ProShares UltraShort Real Estate in Feb ‘09.

Don’t you love it when the market gets irrational like that?

Sometimes, things really are as easy as Buffett suggested when he said, “be fearful when others are greedy, and greedy when others are fearful.” Oh, how I miss the good ole’ days of March ’09, when I could giddily buy into REITs, yacht dealers, credit card companies, and just about anything else in reasonably good financial condition in a disfavored industry; and make a massive return!

It’s Not that Easy Any More

Unfortunately, you can’t get the great deals of ’09 anymore. Yet, even if things don’t look as spectacular as they did in March ’09, I’m here to argue that you can find some select REITs that will offer you attractive dividends, limited downside, and strong fundamentals. These REITs might even be attractive as market hedges.

It’s true that the prices will go down with the market (in most cases), but the dividends will help pad that fall. Moreover, my belief is that the REITs will hold up better than the S&P 500 in any future market correction. All the while, there is enough upside to make them attractive even if the markets continue pushing up.

So here are three REITs I still think are worth checking out:

One Liberty Properties (NYSE:OLP)

I originally bought into One Liberty Properties (OLP) in late ’09. At the time, it looked significantly undervalued and had some significant insider buying; which I always like to see. Most REITs have gained so much over the past two years merely due to overly bearish expectations by the market in ‘09. One Liberty, on the other hand, is one of the few REITs where the underlying fundamentals have not only held up, but have significantly improved. The chart below lays out some of those improvements:

Revenues have increasing by a sizable chunk over the past three years, going from $35.45 million in 2008 to $41.87 million in 2010. Likewise, operating income (adding back depreciation) shows some improvement, too. While “Cash Flows from Operations” excluding working capital changes is roughly flat, it’s worth noting that the 2010 number is held back some by one-time real estate acquisition expenses. If you eliminate those, CFOs are closer to the $20.5 - $21 MM range for 2010.

The best part of all: OLP has a spectacular dividend. With a share price of $14.80, the dividend yield has increased to 8.7%! Even if the stock falls a bit in a market correction, that’s not a bad chunk of change to collect while you wait it out.

There are some risks here, of course. For one, OLP recently conducted a secondary offering. There are reasons not to like this, including the fact that if you believed the company was undervalued, then your undervalued share was just diluted out of some of its value. OLP used the cash from the offering to pay off mortgage debt (weighted average interest rate of 7.9%) and its outstanding credit facility. I question the wisdom of this move, but the bigger point to me is that the offering was only minorly dilutive.

Even after the offering, the stock still sells at about an 8% discount to book value. My own analysis suggests that the company is actually worth a premium to book, in the range of $18 - $22. It may not be a monstrous 100%+ gain, like one could have achieved in 2009, but a 25% gain, and an 8%+ dividend does not sound like a bad consolation prize.

While I would suggest there’s a risk that the dividend could get cut slightly, it should be noted that the company reaffirmed the current 33 cents per share (per quarter) dividend in March (post-offering). And if OLP cuts the dividend, its executives will suffer, too. I like this as a good income stream in the case of a correction; and even if we don’t get a correction, it should hopefully pay out reasonable rewards.

Winthrop Realty Trust (NYSE:FUR)

I’ve written about Winthrop (FUR) a few times before. My investment thesis last March hasn’t panned out thus far. Yet, I’d argue that the fundamentals have actually improved at FUR. The most recent earnings call pleased me greatly. The company has continued to make some shrewd investments and their underlying properties have continued to perform well.

My own quick calculations suggest that FUR is making a slight bit over $1.00 per share from recurring cash flows (i.e. predictable cash flows from its operating properties and some debt instruments). If you completely ignore any potential for appreciation in any of its other assets, it still should be worth in the $12 - $14 range. So at the current price, you are basically buying the recurring cash flows at around fair value, and just getting the more speculative upside bets for free.

Also, like OLP, FUR’s management is heavily invested. CEO Michael Ashner bought an additional $2.4 million in the company back in late September, at prices higher than the current price. Ashner owns about 12% of the company, according to Yahoo Finance.

The dividend stream is attractive here, too. At the current price, FUR is paying a 5.6% dividend, which isn’t bad. I can think of worse things than collecting a large dividend while I wait to see if an upside thesis pans out as expected.

My best guess as to valuation is around $16 - $18, with some reasonable upside potential over that. Once again, not a spectacular gain, but limited downside and a nice dividend stream make that look attractive to me.

Retail Opportunities Investment Corporation (NASDAQ:ROIC)

Finally, there’s Retail Opportunities Investment Corp, with the clever ticker symbol of ROIC. You’ve got to love that one as an investor, right?

I won’t go into too much detail on this one, as Alan Brochstein recently highlighted ROIC, here. Also, there was an excellent article by Tom Egbert on the company several months ago, here. Both of those articles lay out the case for the company better than I can. But the short version is that the company is headed by CEO Stuart Tanz, who has a track record of success in the industry. The company targets shopping centers in higher-wealth areas with a major anchor tenant. It has focused on the West Coast since its inception, but the firm has also indicated it might have some interest in the East Coast/Mid-Atlantic region, as well.

Tanz seems to be targeting around 8% - 9% cap rates according to Egbert’s analysis. Once the company becomes fully invested, it can lever up and the dividend yields will jump.

The stock definitely looked like a good deal in the $9 - $10 range, near its $9.35 book value. It’s on a bit of a surge recently, spiking up nearly to the $11.20 range. It still seems like a reasonably good deal, and the upside could probably be in the $15 - $18 range within the next few years. I like the stock, but I hesitate to recommend after such a spike. Still, it’s good to keep an eye on.

Dividend yield for ROIC is a bit lower than FUR and OLP, at 2.9%, but this might be a better long-term growth play. Downside is probably limited in the near-term to somewhere around $9 (slightly below book value). It’s worth considering and if it dips back down below $10.50, it would become even more attractive. Even under $12, there’s still a significant enough upside to make it attractive.

Conclusion: There are Still REITs Worth Buying

Even if you won’t see the gargantuan returns from ’09, there are still a few quality REITs worth buying into. I’d view these as companies that will give you an income stream, while also possibly giving you some nice upside. If the market falls, the dividend will give you some more cash on the downside, and you can buy into these REITs some more as the prices fall. However, I do believe that next time around, REITs will typically fall less than the overall market.

Disclosure: I am long OLP, FUR, ROIC.