Why I'm Easing Out Of REITs And Into Banks In My IRAs, Starting With Wells Fargo For Realty Income

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Includes: BAC, CCP, FB, JPM, O, OHI, TRV, VTR, WFC, WPC
by: Jim Sloan

Summary

The single goal of my Rollover IRAs is to keep up with Required Minimum Distributions over the next 10 years.

Buying several REITs last August - Realty Income, Ventas, W.P. Carey, Omega Healthcare - accomplished this splendidly last year.

But REITs succeeded so well to prompt review; they moved in a year from very unloved to one of the most loved and expensive areas of the market.

The asset class I think most resembles REITs a year ago is currently banks; everybody hates them, as reflected in their PEs, largely because of the 2008-9 crisis.

I propose gradually easing IRA assets out of REITs and into banks, starting with the most expensive (and loved) REITs.

The goal for my two Rollover IRAs is simple. For the next five or ten years I want a return which roughly replaces the Required Minimum Distributions. This became my strategy last year when I turned 70 1/2 and had to start taking RMDs. My reasons were also simple: (1) to keep the asset value stable for the next five to ten years for my own purposes and (2) to keep the asset value stable for that period for the unlikely event that something happens to me and the IRAs are passed on to one of my children who had a late career change and could use a boost to her retirement. I think she has earned this sort of help.

After that ten-year period I'll take another look. A decade from now the annual RMD amounts will have risen enough that a safe 4-5% return won't do the job. By that time, of course, many things will have changed in the world, the markets, my family, and me. So we'll see.

Why I Bought REITs About A Year Ago

About this time last year I discovered REITs. I had known about them for several decades, but they suddenly presented themselves as the solution to a problem - the problem stated above. My timing was pretty good - partly luck, partly analysis. The market was very worried in late summer 2015 about possible rising rates and what this might do to REITs. Some of the best REITs were down 30-40% from the beginning of 2015. They looked pretty cheap and unloved to me, especially with my modest goal of RMD-beating returns.

Last August I bought REITs with both hands. I started with Realty Income (NYSE:O), then bought Ventas (NYSE:VTR), W.P. Carey (NYSE:WPC), and Omega Health Care (NYSE:OHI). Ventas subsequently spun off Care Capital Properties (NYSE:CCP), giving me a modest position which I kept.

Those REIT buys have all done extremely well - too well, actually. They paid and raised their dividends and their prices went more or less straight up. Realty Income, for one, went from my purchase price around 45 to the low 70s. That's about a 60% pop, the kind of one-year return you might hope for from Facebook (NASDAQ:FB) but not from a REIT - not even a wonderful REIT like Realty Income.

Except for Omega Health Care, my other REITs did almost as well. Omega did its part, though, with a small price gain and a large dividend. All of these REITs, in fact, added to their total return materially with solid dividends. All became more expensive. A repeat performance of this magnitude is, at the very least, highly unlikely.

Now what? One could argue that REITs have become the single most loved area of the market. Everyone has done well with them. They have everything market participants have been looking for - reliable income, the appearance of safety, and future prospects which appear well aligned with the low interest rate environment. Conviction about the near permanence of low rates is another market meme which may possibly be true, but which to my mind is accepted by too many market players with too high a degree of certainty.

Are REITs overloved? Are REITs wildly overpriced? Who knows? One thing I suggest, however, is to look at the number of SA articles going back and forth about Realty Income. Many amount to semantic arguments about the nature of a bubble. That sort of argument doesn't really interest me. All I know is that an asset class which I thought might be 30% underpriced a year ago requires some reexamination if it has 50-65% total return in a year.

Numbers like that tell me to take a step back and think about it. My best success as an investor has come from taking that step back and trying to see the long view. This is what I did when I bought REITs a year ago. The long view, quite simply, is that all the REITs I own are now materially more expensive than when I was buying them.

REITs Seem Overloved And Pricey, What's Hated and Cheap?

About once a week I go through a list of candidates including things like Europe and Emerging Markets, but they all have things wrong with them fundamentally, at least for now, at least for my IRAs. What I want to know is what fundamentally sound market area might be cheap in the same way REITs were fundamentally cheap and sound this time last year. Shhhh, it's banks. Banks!

Are banks really comparable to REITs? Let's think about it. Bank dividends don't quite compare to REIT payouts, but if you think of it instead in terms of total return of capital, including net buybacks, banks may be giving back a very competitive amount to their shareholders. And some blue chip banks like Wells Fargo (NYSE:WFC) and JP Morgan (NYSE:JPM) are within 1% dividend yield of blue chip REITs like Realty Income and Ventas.

But banks aren't safe like REITs, right? That's the prevailing market prejudice - they did almost blow up the world seven years ago, but that's exactly what makes them safe now. They are the most transparent, the best capitalized, and the most closely observed and regulated they have been since my childhood in the 1950s. Warren Buffett thinks this, and so do I. I wrote about it in this recent piece. And only a few days later Oppenheimer, famous for hating banks, did a 180 and said the same thing in great detail.

So how comparable are banks and REITs? In some ways quite comparable, in others quite different. Both are to some degree insulated from the level of economic activity. Both will suffer, to some degree, from economic downturns, but ordinary economic downturns won't likely lead to dividend cuts. There is a core stability to the business of banks, especially now, when they have been forced to live with a flattish yield curve which compresses the key bank statistic - NIM, Net Interest Margin. As I argued in my earlier piece, if banks can make decent money now, under these terrible conditions, they would do very well indeed if long rates ever started to rise.

But the way banks and REITs differ is worth a thought. To grow, REITs depend upon access to capital at reasonable rates. The best, like Realty Income, benefit greatly from low cost of capital - which is greatly aided by the current environment. The current environment may not last forever, however, and even if it does, REITs tend to be serial capital raisers. That's how they grow. As long as they buy properties exceeding their capital cost, you do well. But in any case, if you own a REIT, you have to be prepared to be diluted. Dilution of your ownership is a simple part of ownership.

Banks are currently in the opposite situation. Unable to make loans or investments with satisfactory Net Interest Margins, most of them are investing in the best, most immediate, and cheapest asset available - their own stock. As long as their PE multiples of 12 and below are sustained, that's a great investment. They are fundamentally anti-dilutive - your ownership share of total income regularly increases. They are in this sense the polar opposite of capital raising and dilutive REITs. And they are buying the assets they know best.

This reduction of total shares shows up meaningfully over time, and may produce spectacular bottom line results in an environment more favorable to banks. To see the kind of results this share reduction can produce, one should look at the major property and casualty insurance companies, especially Travelers (NYSE:TRV). Hampered by the same monetary conditions as banks as well as keen rate competition from fly-by-night players, they have cut their common equity shares in half over about a decade, enabling them to regularly increase dividends while paying out less cash from the corporate treasury.

I have enjoyed the result as a holder of TRV, and continue to hold it enthusiastically, but probably would wait for a correction to add. Banks, on the other hand, seem to me in an ideal buy zone.

Here's my thoroughly heterodox first switch: Realty Income out, a major add to Wells Fargo. The next REIT out will be Ventas, after that W.P. Carey - going from the most expensive to the next most, etc. The next bank in might be JP Morgan, or possibly Bank of America (NYSE:BAC) - currently a low dividend payer but potential for outstanding capital return selling well below book value. I still have the greatest regard for Realty Income, Ventas, and W.P. Carey. It's not them, it's me, the long-term value investor.

I will look forward to comments with interest. Poke holes in the idea, but think about it too. I know there's an energetic SA debate on elements of this subject, and I hope to trigger more thoughts on it.

Disclosure: I am/we are long WFC, O, CCP, OHI, VTR, WPC, TRV.

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.