Macro Trumps Micro - Part I: Equity REITs That Even Fortune Tellers Hold

by: The Fortune Teller

I was against equity REITs from mid-2016 till early 2018 (and rightly so!).

Many described me as the "Enemy of the (eREITs) State" (and rightly so!).

Over the past few months, we started buying eREITs (and rightly so!).

Remember: Macro Trumps Micro, Timing is everything and Total Return Matters.


1. It was around mid-2016 when I turned bearish on many equity REITs (VNQ, IYR, RWR, ICF, SCHH, XLRE) At the time, most readers thought that I was wrong and I became known as one of SA's most anti-eREITs contributors.

Chart VNQ data by YCharts

Many commentators viewed me as the "Enemy of the (eREITs) State" but as the chart above suggests - if anything, I gave them the most friendly advice they could have hoped for.

2. One of my most famous (and most controversial) positions was shorting Realty Income (O), the queen mother of eREITs. In this case, I've not only been viewed by many eREITs longs as the enemy of the state but as a real "traitor." Nonetheless, here, too, it's hard to claim that my "stay clear of O" calls (and there were many of those) weren't friendly.

Chart O data by YCharts

Three months ago, I revealed that I cut/hedged this short position by selling a PUT option. While both the short and the option are still alive - the sale of a PUT option, in case this wasn't clear, was a flashing light sign that we're no longer negative about eREITs.

3. The Wheel of FORTUNE is one of SA Marketplace top 20 services that deliver the best returns. That's true on both absolute and especially on a relative (risk-adjusted basis). How do I know? Because many of the top 20 services publish their results. We don't.

4. Many people - especially those who follow me for quite a long time - keep telling me that I suck. Even The Wheel of FORTUNE subscribers tell me occasionally that the service sucks. Why so? Because while we have much to be proud of, we are doing a bad job when it comes to marketing.

5. As a service, we never published an article or built a campaign that was based on our performance. While we think that this is the most (and perhaps only) important factor to be measured upon - we don't think that this is the right thing for us to be using in order to attract more subscribers. We sell other things although we certainly are very minded of performance.

6. Both Trapping Value and I believe that: i) Macro Trumps Micro, ii) Timing Is Everything and iii) Total Return Matters. These three pillars lead us in our analyses and they are building blocks in what our service offers: A constant attempt to eventuate the macro-landscape accurately and when and where we decide to build a house - bringing the appropriate items and material to ensure that the house we build isn't made out of cards...

This article - the first part of a series - is aiming at tackling and possibly fixing most, if not all, of the above issues.

In this series I'll demonstrate the importance of the three pillars we believe in as well as the real difference they are making when it comes to performance.

Macro Trump Micro - Equity REITs Version

Do rising long-term yields affect the prices of eREITs? Some say no, others say yes and there are those who say "perhaps" or "it all depends"... Let's cut this old debate off, shall we? Because no matter what camp you belong to, it's a fact that since mid-2016, (the rising) long-term yields had a major effect on (the declining) eREITs prices.

Chart VNQ data by YCharts

I hope we can at least agree on that.

Now, the thing is that in order to understand that eREITs were vulnerable at that time (i.e. mid 2016) you didn't need anything special; neither from a knowledge aspect nor from a trading perspective. All you needed to do is to ask yourself two simple questions. One before/around mid 2016 and (should the answer to this question wasn't clear to you) another one during the second half of 2016.

1. Before/around mid 2016: How long can this last? Clearly - fundamentally and mathematically - there's not much left to expect/hope for when the UST10Y is at 1.5% (and Fed funds at circa zero) compared to when rates/yields are at 10% or 15%.

Chart 10-Year Treasury Rate data by YCharts

2. During the second half of 2016: Is it time to become less bullish from a technical perspective? You didn't need to be a CFA (or an anti-eREITs SA contributor for that matter) to see that somewhere along the line - the (massively supporting) trend (of declining yields/rates) has broken.

Chart 10-Year Treasury Rate data by YCharts

Completely broken.

For us, mid 2016 was the point where the landscape had changed. As you can see, we needed nothing but common sense and (more important) the willingness not to remain stuck in a position/opinion when the landscape-macro is changing.

The worst thing that an investor can do (to himself) is to ignore the big signs. I'm not talking about the signs that tell you to reduce speed (or to become less bullish, when it comes to the markets). Some obey to those more than others; drivers and investors alike.

I'm talking here about signs like "no entry," "dead end" and/or "one way." Signs that clearly tell you that there's not much road/room left for you to drive/invest in this specific way, even if you insist on keep riding it against the signs!

By the way, this is exactly what differentiates between good writers (content/words) and good investors (returns/actions). While good writers are mostly bothered with compelling reasoning and philosophy, good investors are solely concerned about making money and performance. While good writers mostly employ academic wisdom, good investors mostly (or entirely) employ (Wall) Street wisdom.

These are two different groups that don't necessarily consist/mix the same minds/characters... You can be a great writer and a bad investor as much as you can be a great investor and a bad writer. Of course, you can also suck or be great at both. That still leaves us with two characters that are bad investors.

I don't know about you but as far as I am concern - when it comes to my money I rather it being handled by a good investor more than I care about the investment manager's writing skills.

Bottom Line: Look around without prejudice, analyse the current-valid macro environment without being affected by current positions and/or history and take the necessary decisions that first and foremost suit the macro conditions, way before you go into the micro.

While a lousy stock may shine in a rallying market, a shining stock may find it real hard to rally in a lousy market.

Total Return Matters

Three of the most common claims of Dividend Growth Investors ("DGIs") are:

1. As long as the dividend grows - I don't care about anything else.

2. As long as I'm getting paid on a regular basis - I don't care about anything else.

3. As long as the payout ratio (or dividend coverage) is below (above) 100% - I don't care about anything else.

Okay then, here are five eREITs that are considered to be not only very safe/stable but also meet each and every of the above three claims. Yet, even when we look at these so-called top quality eREITs - four out of the fine names have lost money since mid-2016 and until mid-February 2018: Digital Realty Trust (DLR), Ventas (VTR), Realty Income and Simon Property Group (SPG).

Only American Tower (AMT) managed to post a positive return during that 19.5-month period.

Now, I'm sure that some of you are jumping off your seats, shouting, "why do you pick mid-February 2018 and not another date"? Well, there is a simple answer to that: This is when we started buying eREITs more aggressively. In more simple words, this is when our long-standing bearish stance towards eREITs shifted.

Just to make it clear: We are not bullish on eREITs as a whole right now and we still stay out of most retail eREITs. Nonetheless, unlike the 19.5-month period leading to the February correction - we are now much less negative towards the segment and we are positive about more than a few names.

The thing is that the points we're trying to make wouldn't change even if we stretch the above chart till today.

Chart DLR Total Return Price data by YCharts

From mid-2016 till (and including) 5/14/2018, any of the leading indices - the SPDR® S&P 500 ETF (SPY), the PowerShares QQQ ETF (QQQ) or the SPDR® Dow Jones Industrial Average ETF (DIA) - had significantly outperformed any of the quality eREITs, including AMT.

Why was that happening? Because many (sometimes biased/interested) people claim, eREITs are: i) corporations (not deposits), and ii) yield proxies (I intentionally use yield and not bond).

You can't say "all I care about is the dividend" and, simultaneously, claim that "it's so much more than just yield". I mean, if what you (mostly/only?) care about is what you get paid (dividend) then, by definition, it's all about what the company pays (yield). Btw, that's (the importance of yield) is also true about bonds...

Therefore, if yields rise - and they did/do - the market need to adjust. Any yield-proxy need to adjust!

The below chart shows that since mid-2016, the effective yield on US corporate debts have climbed by ~49% for A-rated debts and by ~26% for BBB-rated debts. The market, including eREITs, had to adjust to that change.

Of course, this is only one aspect of a much broader (macro) frame and there are other factors - e.g. the Amazon (AMZN) effect on retail - that play a (significant) role. However, yield is an important factor and anyone who ignores the trend is doing a major mistake.

Chart US Corporate A Effective Yield data by YCharts

Another factor that is worth paying attention to is spreads = the excess return investors demand from a security versus a free risk similar type of security.

As you can see from the above chart, while yields rose spreads have tightened significantly. This means that investors demand a smaller margin to hold corporate debt compared to the benchmarks - US Treasury debts.

Since spreads are very tight these days, combined with a very low level of fear - as measured by the VIX index (VXX) - it wouldn't be irrational to expect spreads to widen over time, once levels of volatility and fear increase. If so, yields may still have another leg to run up. On the other hand, if spreads widen as a result of heightened volatility and fear - it's also likely that the benchmark yields would move lower. Such an event may see a trade-off between (higher) spreads to (lower) US Treasury yields.

What we see is dividend yields of eREITs that are rising but not as fast as the yield on the UST10Y did. As a result, spreads between the dividend yields to the UST10Y actually tightened over the past year.

Chart DLR Dividend Yield (TTM) data by YCharts

Perhaps a better illustration of this issue is through the below chart which shows that while the yield on the UST10Y has doubled, dividend yields of many eREITs haven't risen as much.

Chart DLR Dividend Yield (TTM) data by YCharts

Bottom Line: We already warned you... Don't solely focus on the dividend growth, dividend safety and payout ratio. There's more to a company - even for an eREIT - than that!

The dividend per share may grow forever, yet in a possibly (much) slower pace than the stock price may decline...

Timing Is Everything

Can you time the market? Apparently not. But what is an attempt to time the market? Does reading a (macro) sign - and acting upon it - should be considered "market timing" or instead be viewed as (as I rather call it) "time in the market"?...

For me, these aren't the same terms. While "market timing" relates to attempts to call for a market peak of bottom, "time in the market" is an attempt to feel where the wind blows, regardless of whether the market is high or low. Furthermore, "time in the market" is an attempt to sense where the wind blows from a risk perspective rather from a performance perspective (as "market timing" tries to do). Putting it differently, while "market timing" is performance related, "time in the market" is risk related.

I trust that everybody agrees that sector rotation is a legitimate action. Nobody claims that "sector rotation" = "market timing" but a reasonable adjustment of a portfolio to risk/reward parameters.

Similarly, a decision to make changes because the risk is too high is not the same as to make changes because valuations are perceived too high. Personally, I believe that both risk and valuation are good reasons - each one on its own merits. However, while valuation may be ignored - that's up to the investor - risk (or more accurately, excessive risk) mustn't.

In mid 2016, both valuation and risk were flashing red when it came to eREITs. You didn't need to be a "market timer" in order to take a decision to step aside and simply wait. Wait for what? Well, as a start for i) dividend yields to rise (alongside yields), ii) dividend yields to reflect the necessary spreads (margin of safety), and iii) valuation (P/FFO) to become attractive again.

As you can see from the chart below, in mid-2016, the average P/FFO* was ~2 multiple points above the long-term average of 16.5x P/FFO.

*the standard REIT equivalent of the price-to-earnings (P/E) ratio.

Three months ago, the average P/FFO stood at ~1.5 multiple point below that long-term average.

At that time, not only were valuations and dividend yields at completely different levels compared to where they were in mid-2016 but another important thing happened: A correction; a real 10% correction.

At the same time Q4/2017 earnings came in, indicating that most sectors continue to see solid growth (in the mid-single digits annually) and demonstrating that eREIT earnings remain very stable (generally speaking).

Valuations seem/ed too conservative, mainly due to the uncertain environment and unknown impacts of the tax reform. With dividend payout ratios still low, this earnings growth should translate into comparable dividend growth. Due to tax reform and the strong economy, eREITs 5%–7% 2018 earnings growth expectations are only about half the FY2018 10% expected growth out of the S&P 500.

Nevertheless, when we look at the (flattening) yield curve - we can't help ourselves thinking that this is the right time to (remain bullish but also to) stick to more defensive sectors, e.g. real estate.

The above chart is implying that a recession may not be too far ahead. I really don't know if it's going to be 2019, 2020 (Ray Dalio says there a 70% chance of a recession in the US before the 2020 election), 2021 or later on but it does seem safe to assume that it's not 10 years down the road.

Regardless of when the next recession may catch us - we believe that 2018 is already a year to be more defensive while remaining (cautiously) bullish.

Bottom Line: "For everything there is a season, and a time for every purpose under heaven" (Ecclesiastes 3); even for eREITs...

More than "better be lucky than smart," when it comes to trading/investing you better be (financially) successful than (academically) right.

February 2018 - Purchase List

Here are few eREITs that we issued BUY trading alerts for (to The Wheel of FORTUNE subscribers) during February 2018:

Symbol Type of eREIT Quarterly Distribution Forward Yield Trading Alert Date Purchase Price Current Price Q4/2017 AFFO Q1/2018 AFFO Payout Ratio Dividend Paid Total Return
GEO Security/Prisons 0.4700 8.07% Feb. 5, 2018 20.68 23.29 0.67 0.57 82.46% 0.94 17.17%
IRM Storage 0.5875 7.18% Feb. 5, 2018 33.00 32.75 0.57 0.78 75.69% 0.59 1.02%
KRG Retail 0.3175 8.76% Feb. 6, 2018 14.76 14.49 0.50 0.51 62.25% 0.32 0.32%
WPC Industrial 1.0100 6.24% Feb. 12, 2018 59.50 64.750 1.31 1.28 78.91% 1.02 10.53%

Here is how the quarterly dividend (per share) growth looks like for this quartet:

Chart GEO Dividend Per Share (Quarterly) data by YCharts

The GEO Group (GEO)

Credit ratings: BB-/B1 >>> We would like to see/get a minimum spread of 375 bps (or 3.75%) over the UST10Y.

Dividend Yield >>> BUY at 9% or higher, SELL at 7% or lower.

2018 Guidance >>> Based on AFFO of $2.49 (at midpoint) and P/FFO of 11 the stock price target is $27.40

Source: Company's Q1/2018 earnings call slides

Iron Mountain (IRM)

Credit ratings: BB-/Ba3 >>> We would like to see/get a minimum spread of 350 bps (or 3.5%) over the UST10Y.

Dividend Yield >>> BUY at 7% or higher, SELL at 6% or lower.

2018 Guidance >>> Based on AFFO of $2.92 (at midpoint) and P/FFO of 13 the stock price target is $38.

Source: Company's Q1/2018 earnings call slides

Kite Realty Group Trust (KRG)

Credit ratings: BBB-/Baa3 >>> We would like to see/get a minimum spread of 300 bps (or 3%) over the UST10Y.

Dividend Yield >>> BUY at 8% or higher, SELL at 6.5% or lower.

2018 Guidance >>> Based on AFFO of $2.01 (at midpoint) and P/FFO of 10 the stock price target is $20.

Source: Company's Q1/2018 earnings

W.P. Carey (WPC)

Credit ratings: BBB/Baa2 >>> We would like to see/get a minimum spread of 300 bps (or 3%) over the UST10Y.

Chart Fundamental Chart data by YCharts

Dividend Yield >>> BUY at 6.3-6.4% or higher, SELL at 5.7-5.8% or lower.

2018 Guidance >>> Based on AFFO of $5.40 (at midpoint) and P/FFO of 13 the stock price target is $70.

Source: Company's Q1/2018 earnings transcript

Bottom Line

  • Macro Trumps Micro. eREITs have reached the point where the risk/reward is attractive, especially when the rally is older than 9 years and the next recession is likely to be closer than 9 years ahead.
  • Total Returns Matter. You may grow your dividend for years and maintain a decent payout ratio and still end up with a massive loss.

Chart KIM data by YCharts

  • Timing Is Everything. It's not only about knowing when to spin the wheel but also about when to get off the table and let the game run without you.

Image result for wheel of fortune

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Disclosure: I am/we are long GEO, KRG, IRM, WPC. 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.