We live in a highly uncertain world. The US economic outlook may be bright today with 4.1% GDP growth in the second quarter and historically low unemployment rate of 3.9%, but the rest of the world remains exceptionally fragile with slow growth in Europe and Asia, and growing geopolitical uncertainty with trade wars, tariffs and growing populism. Moreover, with central banks continuing to experiment questionable policies, we see increasing risk of accelerating inflation.
In such times of high uncertainty, we ask ourselves: where to allocate capital in 2018?
Obviously, there is not one correct answer to this question, and investors should take into account their personal risk tolerance and return objective. That said, we believe that today may be the time to become more prudent, and this means more defensive sectors such as real estate or REITs, and less traditional stocks of cyclical companies. Here is why:
REITs in Times of Uncertainty
REITs stand for "Real Estate Investment Trusts" and represent large publicly traded companies investing in income properties. They are one of our personal favorite investment vehicles today, because unlike most other stocks:
- The income is exceptionally consistent and predictable.
- They enjoy consistent growth.
- They pay high dividends.
- Real estate is a good hedge against inflation.
In other words, in a context of rising uncertainty, we consider real estate to be an increasingly attractive asset class in comparison to others. The risk profile is generally lower due to the infrastructure-like necessity of real estate, and toll-road like earnings of lease contracts.
Lower risk is supposed to be rewarded with lower returns in an efficient market, and yet, REIT investors have grown much richer than the average stock investor. Today, more than ever, we are pleased to hold many REITs in our Portfolio that enjoy consistent cash flow, pay high dividends, and have inflation protections.
REITs Generate Consistent Cash Flow
One of the major advantages of owning and managing income properties is that their earnings are fairly stable and predictable. This is largely due to the fact that most REITs derive their cash flow from long-term contracts (leases) and are hence protected from market cycles to some extent. If tomorrow we went into a recession, most commercial real estate landlords would keep on receiving their rent checks regardless of the economic conditions as long as the tenants did not default. Real estate investors are not immune to losses, but at least they may receive a consistent paycheck while they endure difficult times. Great examples of this are net lease REITs Realty Income (O) and National Retail (NNN) which were barely even affected by the great financial crisis.
REITs Pay High Dividends
Another important characteristic that differentiates REITs from most other common stocks is that they pay significantly higher dividends than the average. This is because REITs must, by law, pay out at least 90 percent of their taxable income in form of dividends to its stockholders.
As an example, at High Yield Landlord, our HYPO Portfolio has a 7.6% ongoing yield, despite a low payout ratio of just 71%.
The higher cash return reduces risk and increases the safety of returns as the stockholders are legally entitled to most of the cash flow even during occasional bear markets. REIT investors are thus less dependent on stock market appreciation to generate attractive returns compared to most other stock investors.
Finally, since REITs cannot retain much of their earnings, they will rarely be aggressively valued based on high expected growth rates. The risk of future earnings disappointments and excess volatility is thus reduced as expected growth might not be achieved.
REITs Protect Against Inflation
In times of increasing inflation, REITs may provide natural protection against it as they are backed by real assets. Real estate rents and values tend to increase with inflation. In fact, most leases are today directly tied to an inflation index and rent increases can be automatically enforced. This supports REITs' dividend growth and provides a reliable stream of income even during inflationary periods. Research from NAREIT demonstrates that REIT dividend growth has outpaced inflation as measured by the Consumer Price Index in all but two of the last twenty years.
Stocks also protect against inflation shocks, but often less so than REITs and real estate.
REITs Have Greater Margin of Safety
Regardless of what valuation metrics you look at, all the evidence points out that REITs are cheap today. On a cash flow multiple basis, Lazard notes that REIT valuations have now fallen 20% below the long-term average of 16.5x FFO.
Source: Lazard Real Estate
The current P/NAV also suggests that REITs are substantially undervalued at a 4-7% average discount compared to a 2-3% long-term average premium.
Source: Lazard Real Estate
On the other hand, the broad equity market trades at all-time highs with a P/E ratio close to 25, or up to a 40% premium to its historical average.
REITs have significantly less optimism and growth priced into their share prices - providing greater margin of safety. Priced at just 10-15x cash flow and discounts to NAV, REITs do not need to generate much growth to generate attractive total returns to shareholders. The same cannot be said about most large-cap stocks including Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) or Netflix (NASDAQ:NFLX) which rely on strong growth to continue generating attractive returns.
- The global economy is highly uncertain.
- Geopolitical risk is rising.
- There is risk of accelerating inflation.
- REITs enjoy stable cash flow, high dividends, and inflation protection.
- REITs are set to profit.
Source: REIT Watch
Our HYPO portfolio is very well positioned for the long run with mostly high-quality companies trading at deep discounts to peers or NAV. The 7.6% dividend yield is covered with a low 71% payout ratio, and we expect new dividend hikes to be announced in the coming quarters. To gain access to our full portfolio holdings, along with real-time alerts on real estate opportunities along with regular market updates, join us today at High Yield Landlord with a 2-week FREE trial. Click HERE.
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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.
Additional disclosure: This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer. Readers are expected to conduct their own due diligence or seek advice from a qualified professional.