The More It Drops, The More I Buy - Revisited

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Includes: AMZN, COIN, EPR, FB, GPT, IRM, KIM, KO, LXP, NFLX, O, PSA, SKT, SPG, SPY, SRC, STAG, STOR, VNQ, VTR
by: Jussi Askola

Summary

Once again, REITs recovered the majority of their losses after a painful first quarter.

Historical data suggest that REITs will keep outperformance even in times of increasing interest rates.

Fundamentals are exceptionally strong today with REITs having the lowest debt levels ever and enjoying solid NOI growth.

We share 3 top holdings of our “High Yield Property Opportunity” (HYPO) Portfolio at High Yield Landlord.

We hate to say it but we told you so… When REITs sell off due to interest rate fears, it is time to load up on temporarily discounted shares. It is now the 4 th time that we make this same call on Seeking Alpha (with the same title) and each time the results have been same:

REITs sell off leading to interest rate hikes, and quickly recover their losses thereafter.

Recognizing this pattern, we have at many times been able to benefit from the repetitive drops by buying low just to a few month later resell the same shares at higher prices for a short-term profit.

Most recently, we encouraged readers to buy the drop in February and later reaffirmed our stance in April when REITs continued to sell-off.

Investors spend lots of time worrying about interest rate hikes when it comes to REIT, but not so much trying to figure why this should be an issue in the first place. By studying history as well as fundamentals, we find this very interesting. While the common wisdom remains that REITs should be avoided in times of increasing interest rates, we continue to note that this conclusion is not backed by historical evidence, and neither by fundamentals.

Buy Low – Sell High

Historical data shows that buying REITs right after a sell-off is very likely to result is strong future outperformance. REITs have over their 30+ year history suffered tens if not hundreds of sell-offs varying in intensity and duration; and yet they have always eventually recovered to new highs and outperformed broad markets.

Source: NAREIT

This is especially true when the sell-off is due to interest rate fears. Research shows that opposite to the common belief, REITs have historically performed relatively well during times of interest rate increases. In fact, REITs (VNQ) outperformed the S&P 500 (SPY) in more than half of the episodes of rising treasury yields over the period 1992Q1 to 2017Q4. In 87% of the episodes of rising Treasury rates, REITs generated positive total returns during that same time frame. While it may be surprising to many, it really shouldn't be because:

  1. Interest rate hikes often come together with strong economic growth and inflation – which are both bullish for real estate and REITs.
  2. REITs may benefit from higher demand for space and achieve higher occupancy rates.
  3. The higher demand may also allow REITs to increase their rents when leases expire.
  4. Higher interest rates commonly lead to higher cap rates which may result in more profitable future investments and rapid external growth.

Taking these 4 factors into account, we are happy buyers of REITs whenever investors become concerned over interest rate hikes. The volatile market sentiment may influence pricing over the short run, but fundamentals trump pricing in the long run.

Strongest Balance Sheets Ever… and High NOI Growth…

Today, the fundamentals of the REIT market are particularly favorable to sustain another period of interest rate hikes as leverage is at an all-time-low and NOI is growing at a fast pace.

source

REITs have steadily fortified their balance sheets since the great financial crisis – leaving the industry in a financial position it has ever seen before. The leverage levels are very reasonable today with the average debt-to-assets at just ~30% - which compares very favorably to the many private equity real estate investors who often use up to 80% debt to finance deals. Moreover, it should be noted that most of this debt is long term and fixed rate, and as such, the exposure to interest rate movements is minimal today.

While the balance sheets are stronger than ever before, NAREIT notes that REITs are achieving fast growth today with increasing rents and occupancies.

Current operating performance for the REIT industry is right in its “ sweet spot”: over the last four quarters, same-property NOI growth averaged 3.2 percent, consistent with the industry’s long-term norm. Same property NOI growth greater than about 4 percent can be “too much of a good thing,” stimulating so much new construction that it results in oversupply that reduces occupancy rates and rents, eventually suppressing same-property NOI growth to its “soft” range of 2.5 percent or less.

Therefore, we conclude that the operating environment of REITs remain solid and promising, even if rates continue to increase.

In this sense, our “ buy low - sell high” approach to buying market dips continues to apply going into the second half of 2018. In fact, we would go as far as to say that we hope REITs would suffer another sell-off. We have fresh capital to invest, and finding new opportunities is getting harder and harder as prices keep climbing up. Back in April, this was very easy as literally every REIT was on sale including the highest quality names such as STORE Capital (STOR), Realty Income ( O), Kimco ( KIM), STAG (STAG), Simon ( SPG) and Ventas ( VTR).

Today, REITs remain underpriced relative to most other asset classes, but the magnitude of the discount has come down. With this in mind, let’s have a look at where we currently see the best opportunities.

What Are We Buying Today?

Not every REIT sold off to the same extent in the first half of 2018, and not every REIT recovered its losses in the same magnitude either.

Studying fundamentals in relation with valuations, we consider the 3 following REITs to remain highly opportunities today:

Lexington Realty Trust ( LXP) is currently a diversified REIT in transition to becoming an industrial REIT. The portfolio repositioning has almost doubled the exposure to industrial assets in the last 5 years bringing it to about 50% of total assets. While industrial REITs trade on average at about 20x FFO, LXP trades at just 9.5x expected FFO today. It is not a “pure-play” industrial REIT and therefore deserves to trade at a discount to industrial REITs, but given that half of its assets are of the same nature, I consider this discount to be highly excessive. While we wait for the potential upside to materialize, we get an 8.1% dividend yield which is covered with ample cash flow at a ~75% payout ratio.

Spirit Realty Capital ( SRC) is our one and only pick within the net lease sector today as it remains deeply underpriced relative to peers despite holding very similar assets and possessing a strong balance sheet. The recent for this discount are past missteps in capital allocation which appear to be resolved today after the recent spin off of lower quality assets. Trading at an 8.5% dividend yield and just about 12x AFFO, I see ample upside and would not be surprised if the REIT was to be acquired by one of its peers.

Iron Mountain ( IRM) is a niche player in the storage industry focusing on business clients rather than consumers. Instead of renting place to Jack so he can store his jet ski, IRM leases space for Coca-Cola ( KO) to store its mountains of paper records. IRM enjoys a strong moat in the sector as the leader providing space to 95% of Fortune 1000 companies. Compared to self-storage, the demand and supply dynamics appear more favorable relative to the pricing of assets today – making IRM more opportunistic compared to Public Storage ( PSA) like companies.

In addition to these 3 high yielding REITs, we currently hold 12 other in our “HYPO” Portfolio - seeking maximum total returns with an ~8% on-going yield from real estate investments. In our last article of this same series, we suggested 3 different companies, namely that EPR (EPR), Gramercy (GPT) and Tanger (SKT) were solid opportunities. Here are the results since then:

Final Thoughts

The main reason why we like real estate and REITs so much is because at the end of the day, we are not smart enough to predict what will happen to Bitcoin (COIN), Facebook (FB), Amazon (AMZN) or even Netflix (NFLX) in the long run. We know however that quality real estate bought on the cheap is a strategy that is expected to result in favorable performance.

In this sense, rather than trying to pick the new “high grow” “high tech” company, we stick to what we know and understand best: real estate. We recently launched High Yield Landlord, a premium service dedicated to uncovering the most profitable and newest high dividend ideas in this sector. We are offering a reduced-legacy rate for 76 more subscribers. The offer ends on August 15 th, and the price will never be this low again.

Lastly, we want to thank all the readers who have followed “The More it Drops, The More I Buy” series in the past. Let's keep the debate going. What do you think about REITs? Comment below…

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Disclosure: I am/we are long ALL STOCKS IN HYPO PORTFOLIO.

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.