Buy Simon Property Group, Better Potential Return And Less Downside Risk Than Most Triple Net Lease REIT
Summary
- Property forms a large component of my investment allocation at about 20%.
- In a rising rate environment, I have slightly reduced this allocation but also switch towards REITs with lower sensitivity to interest rates.
- I focus on REITs that have lower distribution ratio and can generate higher internal growth.
- SPG is high quality, delivers 5-6% internal growth and has just increased its dividend. I see a total return of over 11%without any external growth.
Introduction
This article will not cover SPG in details. Rather it explains the rationale to switch out of high distribution triple-lease REIT that relies on external growth towards names like SPG (NYSE:NYSE:SPG) or even fallen angels. We estimate this strategy will provide better return and less downside risk.
In this article, we compare the total return of a buy and hold investor.
SPG can deliver 11% total return (without external growth) and has a downside risk of about 15% if rate rise by 1% (1.4 years of returns).
In comparison, Realty Income (NYSE:O) can only deliver a 7-8% return (without external growth) and has a much greater downside risk of about 30% if rate rise by 1% (4.5 years of returns).
What are the components of total return in a REIT
For a buy and hold investor, the total return is the future dividend stream.
The key drivers are the dividend, dividend coverage, and the potential growth. Seeing the total return as being the dividend plus the dividend growth is a good rule of thumb.
The sustainability of the dividend growth matters a lot. This article will compare the sustainability of the dividend growth of SPG vs. Realty Income which both offer similar dividend yield.
How Sustainable is the dividend growth: SPG vs. Realty Income
Realty Income: limited potential dividend growth from external acquisition
Triple-net lease REITs rely on external acquisition to deliver 50-70% of their dividend growth. At their current dividend yield, external acquisition are barely or no longer accretive.
Dividend growth, for a name like Realty Income, will fall toward the 2 - 2.5% range which can be generated organically. This will reduce the potential total return to the 7 - 8% range (dividend yield plus 2-2.5% growth) from the 10% range (dividend yield plus 5% growth). Some elements
- Organic Growth. On the current same-store growth of ~1% and 83% distribution rate, Realty Income can generate about 2.6% of dividend growth from its portfolio (escalator and free cash flow).
- External Growth is needed to fuel dividend growth. On current market terms, it is very difficult as illustrated in table 1 and 2.
- For example in table #1, you can see that when acquisitions were financed with equity yielding 4.3% (12 month ago), 1.5bn of purchase would have brought a 5% dividend growth but
- At today's yield it will only increase growth from 2.6% to 3.2%.
Table # 1: Realty Income Source of Growth
Indeed on current dividend yield, cost of debt and cap rates, external acquisition are barely accretive in year 1:
- Under the assumption shown in table 2 below, the Accretion Effect Per 1 share issued (cf table 2) has been reduced significantly meaning that most of the new income is used to finance the new shares.
- A small 0.3% increase in dividend yield would make acquisition negatively accretive (cap rate remaining equal).
- In the current market, Realty Income would need $8bn worth of acquisition to reach a 5% dividend growth... the number looks silly because we are close to the break-even point.
- Overtime cap rate may increase with inflation, but that may take time.
Note that the retained earnings investment also suffers (line New Invest Return), but to a much lower degree than the accretion effect for newly issued shares. This means that if you rely on internal growth, a small rise in interest rates (1% that takes you from the middle to right columns) will only reduce your return by 10% (7.9 to 7.2%) whilst it is sufficient to remove the benefit of external growth.
I believe that the market overestimates Realty Income ability to grow in the coming years. At the USD 49 per share price, I estimate a 7 - 8 % return for a buy and hold investors.
SPG: internal growth to deliver 5 - 6% dividend growth in the coming years
The situation is much better for names that have lower distribution and higher rent growth. Their ability to deliver growth is not only linked to their relative market valuation.
SPG meets both criteria with a sub 70% distribution and strong same-store growth of around 3% (Investor website).
Furthermore, SPG is both a developer and property owner, and through the development, aspect will tend to extract higher return giving higher protection against spread compression than a REIT buying completed properties like Realty Income.
At the USD 155 per share price, I estimate an 11% total return and potentially more with acquisition.
Table 3: SPG no need for external acquisition to get 6% dividend growth
What downside risk when rates rise: SPG offers so much less volatility
REIT suffer when interest rises. The impact since Q1 2016 is greater than the simple increase in the discount rate; this accounts for the tightening of the spread of new investment as well.
However, all REITs are not equal, in this article, we focus on the relative effect of relying on external acquisition for growth.
Realty Income is at risk of 3 effects compounding to a 30% downside risk for a 1% rise in interest rates:
- Cost of capital increase by 1% from 9.2% (we start in the orange box, with a 4% implied growth) to 10.2% taking the stock down to 39
- At 39, the dividend yield of 6.7% kills off any remaining possibility of external growth, as per our claim above, taking the implied growth rate from 4% to 2.5% or 35
- With limited growth, should Realty Income trade at a lower cost of capital than SPG... probably not, if its cost of equity matches SPG at 11%, the stock may fall to 32 completing a 30% drop
Note: in yellow, the high point is restated for the dividend growth since
Looking at SPG, the 5-6% growth is driven by internal growth and reinvestment of free cash flow, the main impact of a rate rise would be an increase of the implied cost of equity of the 10% range to 11% taking the stock down by about 15% (still painful but at least we earn an internal rate of return of 11%)
Realty income premium valuation (from a CoE perspective) and potentially overestimated growth prospects make it riskier than a beaten down stock like OHI or CBL (disclosure I am long CBL via short puts). OHI (NYSE: OHI) probably as the lowest sensitivity in rate rise (high dividend means lower duration) as rate rise will not further depress the potential for growth when it is already very low.
Conclusion
The rise in rates and dividend yield threaten the business model of REITs that rely on external acquisitions to fuel their dividend growth.
The reduction in their growth rate will reduce their potential return and put them at risk of further price decline.
I find better value in names like SPG: higher organic total return, greater balance sheet flexibility and higher current implied cost of capital offer a better risk - reward in a volatile environment.
This article was written by
Analyst’s Disclosure: I am/we are long SPG, CBL, KLPEF, HMSNF. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (17)
One more question: any thoughts on SRG? Buffet bought SRG, and also there was an article in Barron's that in about10 years SRG woud be 10x bagger, although it might have some problems meanwhile, if (or when) SHLD goes BK. But eventual result would be same 10x!
I dislike realty income in this rates environment, I think the inability to grow dividend meaningfully can put the stock price under great pressure (see the article!)
I don't follow VTR, if you don't have access to investment banking research, maybe the guys at Hoya Capital have written something on it.