5 Undervalued REITs Going Straight Up

Includes: EQC, GOV, HCN, HST, MFA
by: Neoclassical Economist

Real estate investment trusts (REITs) are a unique asset class. Since they are required to pay 90% of their taxable income in the form of dividends, the shareholders benefit from directly pocketing the majority of these profits before they are taxed, rather than seeing them go towards executive bonuses and other undesirable and sometimes nefarious ways. REITs are considered a good hedge against inflation, since landlords can usually raise rents as their costs increase, and REITs' prices typically don't fluctuate as much as most other stocks.

According to an analysis by Moody’s Investors Service, published in October 2011, investment grade-rated REITs in the United States are relatively well-prepared to weather a possible recession. Even though the risk of a recession is now seen as being higher mainly due to the European debt crisis, REITs are expected to be much less affected by a recession than they were in 2008. Moody’s indicated that REITs’ average effective leverage is at around 44%, down from 51% in 2008. As such, REITs are in a better position to cover their debt maturities and also have large unencumbered asset pools that provide an avenue to raise cash during a crisis.

Here are five REITs that have significant upside potential:

CommonWealth REIT (NYSE:CWH), formerly HRPT Properties Trust, owns and leases office and industrial properties all over the US and Australia. At $16.00, the stock is at a 52-week low and has been under pressure for the past three months. It certainly didn’t help that Stifel Nicolaus downgraded its rating on this company from Hold to Sell on Nov 4th, when the price was $18.25.

CWH’s Q3 2011 normalized funds from operations (FFO) came in at $70.0 million, or $0.86 per share, or slightly lower than Q3 2010. As of September 30, 2011, 87.0% of CWH's total square feet was leased, compared to 87.5% as of June 30, 2011. As such, I don’t see any signs of trouble, and certainly nothing to warrant the exaggerated price drop of 20% since August. With a yield of 12.50%, book value of over $32/share, and forward P/E ratio of 4.73, this stock is a strong buy.

Health Care REIT (NYSE:HCN) is a real estate investment trust that invests across the full spectrum of seniors housing and health care real estate. Its portfolio is broadly diversified and consists of 898 properties in 45 states. The company also provides an extensive array of property management and development services. The healthcare sector is one of the more recession-proof real estate sectors; in addition Health Care REIT has mostly long-term triple-net leases in senior housing and healthcare real estate properties that insulates it from market volatility and provides a steady source of revenue despite a challenging macroeconomic environment. This offers a strong upside potential for the company.

HCN recently reported Q3 2011 FFO (funds from operations) of $0.85 per share compared with $0.31 per share in the year-earlier quarter. During the quarter, HCN made gross investments of $644 million, including $569 million in acquisitions. On November 9 HCN announced a rather sizeable secondary market offering, which has brought the stock price down to the very attractive level of $48/share with a solid yield of 6%.

Host Hotels and Resorts, Inc. (NYSE:HST) is the largest lodging REIT in the US. The firm primarily invests in luxury and upper upscale hotels, including the Marriott, Ritz-Carlton, Sheraton and Hyatt hotel chains. The Company currently owns 105 properties in the United States and 16 properties internationally totaling approximately 65,000 rooms. HST also holds non-controlling interests in a joint venture in Europe that owns 13 hotels with approximately 4,200 rooms and a joint venture in India that is developing seven hotels in three cities with approximately 1,800 rooms. Key statistics include a forward P/E ratio of 11.75, price/sales of 1.84, and price/book value of 1.31, and yield of 1.25%.

Government Properties Income Trust (NYSE:GOV) owns and leases office buildings that are leased to government tenants. In fact, the majority of its rentable area is occupied by federal government agencies. GOV currently boasts a 96% lease-up rate and a solid dividend yield of 8.3%. At $20.22 a share this REIT is practically on sale after it dropped from the high $20s following the July secondary share offerings. As I wrote recently, GOV acquired a number of leased properties in 2011 at attractive prices as it is continuing to grow.

MFA Financial, Inc. (NYSE:MFA) is a mortgage REIT, engaged in investing, on a leveraged basis, in residential Agency and Non-Agency mortgage-backed securities (MBS). At $6.41/share, MFA is yielding a whopping 15.6% and this yield does look sustainable. The company has not made the mistake that other REITs made by loading up on interest rate swap hedges. Instead, MFA focuses on buying MBSs, lately more on the non-Agency side, at below market value, which could provide a huge boost to book value if and when housing conditions improve.

MFA’s Q3 2011 core earnings came in close to expectations at $0.24/share. I expect that dividends will remain at $0.25 even though that is higher than earnings. This may look like a discrepancy, but actually MFA typically distributes approximately 100% of its REIT taxable income on an annual basis. So, for all its Non-Agency MBSs acquired at a discount, core earnings are reduced by credit reserves for estimated future losses while taxable income is reduced by realized losses only when they actually occur. As a result, dividends can and often do exceed core earnings.

Disclosure: I am long GOV.