Tax Loss Selling Impact
With rising GDP growth, robust job growth, record consumer confidence and favorable legislation in the form of reduced taxes and regulation, numerous stocks performed very well for much of 2018. Over this period of time, many investors elected to take gains on some of their most successful positions. Although taxes are lower than they were last year, they are still high enough for investors to actively reduce them where they can. Tax loss selling, using trading losses to “wash” trading gains, is being heavily utilized in November and December so as to reduce 2018 taxes owed come April 15, 2019.
In order to offset gains taken earlier in the year, investors are now selling off some of their most beaten-down securities. These securities are not being sold on the basis that their already substantially reduced share prices are overvalued, but rather because selling the largest unrealized losses can wash the greatest amount of realized gains. This would not create a major impact if it were just a few investors engaging in this tax loss selling for each security, but stocks that have fallen a substantial amount represent an appealing tax loss selling option for all of the investors who held that security over any period in which it meaningfully declined. As a result, many investors sell off an already beaten-down security, causing its share price to fall even further. This allows the next sellers to take an even larger loss and thus wash even more realized gains, which of course pushes the share price even lower. This downward spiraling process continues throughout tax loss selling season, leaving some securities at staggeringly large discounts to peers.
Value investors, however, will begin to aggressively swoop in and buy up these cheap securities around the beginning of the year (but at least 30 days after they sold the security so as to avoid creating a “wash sale” which would nullify the tax savings of selling it for a loss). Considering that the share prices of these securities were pushed down to levels far lower than they were trading before tax loss selling season, there is tremendous upside in merely returning to the already beaten-down prices they were at before November. In this article I will attempt to identify the securities which have been most negatively impacted by tax loss selling and highlight opportunities for which there is substantial upside potential.
Stock Market Performance Has Become Detached from Economic Fundamentals
The economy continues to heat up and 2018 is on track to be the first year of 3%+ GDP growth since 2005. 2nd quarter and 3rd quarter GDP growth came in particularly hot at 4.2% and 3.4%, respectively. The unemployment rate continues to fall, reaching a 49-year low of 3.7%. Wage growth is picking up steam as well reaching 3.1%, providing workers with their best wage gains in 9 years. Lower taxes and higher wages have provided consumers with more disposable income, which in turn is leading to better sales figures for retailers. Mastercard SpendingPulse reported that U.S. holiday retail spending (Nov. 1st – Dec. 24th) increased by 5.1% and online holiday spending rose by 19.1%. This represents the best holiday shopping season in 6 years.
With businesses generating better earnings and consumers bringing home a higher portion of a larger paycheck, one would expect the stock market to be performing very well. Share price performance, however, has over recent months become almost completely detached from the strength of the economy and in many cases the strength of the companies that have issued the shares. This mispricing has created a tremendous opportunity to acquire shares of strong companies at a rare discount or shares of decent companies at fire sale pricing.
The Data Clearly Demonstrates a Substantial Tax Loss Selling Impact: A Closer Look by Property Type
During the first 10 months of the year, every single Data Center REIT underperformed the REIT sector as a whole. However, the Data Center REITs with the biggest losses were QTS Realty Trust (QTS), CoreSite Realty Corporation (COR) and Equinix (EQIX). These same 3 REITs have also been the 3 worst performers since the beginning of November. This further selloff is undoubtedly the product of tax loss selling season, as investors take tax losses to wash gains from earlier in the year, selling off their worst-performing securities to wash the greatest amount of gains.
The two worst-performing Healthcare REITs during the first 10 months of the year, New Senior Investment Group (SNR) and MedEquities Realty Trust (MRT), took even larger beatings during November and December as they were targeted for tax loss selling. Both securities are now excessively oversold, both MRT and SNR have stated in 2018 that they are exploring “strategic alternatives” including the potential sale of the company. Given how discounted the share prices of both companies have become, it could be far more accretive for private equity or another healthcare REIT to acquire either of these companies than to purchase similar assets in the private market. Needless to say, being acquired at well-below NAV yet well-above current pricing would result in substantial gains for shareholders. MRT is trading at a particularly discounted price given that the company has already pre-announced that it expects to announce in January that the common dividend will be reinstated.
Plymouth Industrial REIT (PLYM) and Monmouth Real Estate Investment Corporation (MNR) saw double-digit negative returns during the first 10 months of the year as many of their industrial REIT peers saw strong positive returns. This left both securities vulnerable to tax loss selling and both REITs saw their share prices fall from in the $18 range down into the $12 range within the last year. Although both stocks have been oversold, PLYM is currently far and away the most attractively priced Industrial REIT, trading at a 10.5x multiple in a property type that currently averages a 19.9x multiple.
Uniti Group (UNIT) was the best-performing Infrastructure REIT during the first 10 months of the year, so at first glance it may seem odd that it declined substantially during tax loss selling season. Although UNIT performed well through much of 2018, it has plummeted from a high of $32.70 in September of 2016 down to $14.89 on Christmas Eve. This provided many longer-term investors with the opportunity to take sizable capital losses to wash other gains. UNIT, an infrastructure REIT that owns fiber and towers which it leases to customers, initially declined in share price due to the struggles of the primary tenant Windstream Holdings (WIN). It fell further due to a lawsuit against Windstream that has been extensively covered on Seeking Alpha. Although UNIT has steadily diversified away from Windstream and Windstream has made substantial progress over recent quarters and is an increasingly stable tenant, UNIT continues to trade at incredibly low prices while investors await the judge’s verdict in Windstream’s lawsuit. There is tremendous near-term upside potential in the event of a favorable ruling and given that Windstream is expected to continue to pay the master lease rent in full in the event of an unfavorable ruling, the downside risk is somewhat mitigated. UNIT also possesses a substantial amount of dark fiber that could be “lit,” which would provide additional growth with minimal capital expenditures.
In 2018, Farmland Partners (FPI), a farmland REIT, was hit hard by increased investor uncertainty stemming from the ongoing trade war with China, and it was hit even harder by tax loss selling. Despite recent trade progress with China (China has begun purchasing US soybeans again and announced that for the first time it would allow US rice to be exported to China), FPI’s share price has been in free-fall. As tax loss selling concludes and trade talks with China (hopefully) continue to progress, FPI has the potential to rise as quickly as it fell. Trading at only 50% of its 52-week high, FPI has huge upward potential and is one of the most potentially lucrative opportunities among all REITs.
Anyone who has turned on a TV or opened a newspaper in the last few years has heard the “death of brick and mortar retail” narrative. This narrative has been pushed particularly hard against class B and C malls. This narrative is certainly accurate for certain malls in certain regions, but non-top tier mall REITs are being sold off as if every single one of their properties is composed exclusively of Sears and Toys“R”Us tenants. As a result, REITs such as CBL & Associates Properties (CBL), Pennsylvania Real Estate Investment Trust (PEI) and Washington Prime Group (WPG) have fallen precipitously over the past few years. As a result, they trade at shockingly low FFO multiples. CBL and WPG are currently trading at the lowest FFO multiples in the entire REIT sector at 1.08x and 3.18x, respectively.
As I referenced earlier in the article, holiday retail sales are coming in strong. CBL and WPG are both making steady progress toward transitioning their malls into “town centers,” moving away from the old big box store model and focusing more on dining and entertainment. Some of the old big box stores have been converted into bowling alleys, Dave and Busters or even a casino. Some of the spaces that were previously occupied by big-box retailers that paid a low rent per square foot are being divided up into several smaller and more popular retailers which each pay a higher rent per square foot. Both CBL and WPG have enormous upside potential in both the near term (bouncing back from aggressive tax loss selling) and long term (as the portfolio redevelopment is completed).
The two Manufactured Housing REITs that outperformed the REIT sector as a whole during the first 10 months of the year held up well during tax loss season. UMH Properties (UMH), which had underperformed the market in 2018, was sold off aggressively during tax loss selling season. Although it may seem that UMH would not be a great opportunity for investors to take capital losses given that it finished October flat year to date, it is important to note that many investors who had purchased UMH mid-year at prices as high as $16.69 had generated substantial losses going into tax-loss selling season. Such a tremendous tax-loss induced selloff (-20%) has created a very attractive opportunity to buy up (at heavily discounted prices) this well-managed growth REIT that reported a stellar 8% same property NOI growth in 3Q 2018.
Multifamily REITs performed moderately well over the first 10 months of the year, with the exception of Preferred Apartment Communities (APTS) which saw a double-digit decline. This decline provided investors an opportunity to harvest taxable losses by selling APTS in November and December. After this selloff, APTS is now trading 36% below its 52-week high and has become the most attractively priced Multifamily REIT. APTS is well-positioned to bounce back in the early part of 2019 and outperform the REIT sector as a whole.
The Office REIT that had seen its share price fall furthest during the first 10 months of the year, Government Properties Income Trust (GOV), was also the office REIT that was hit hardest by tax loss selling. This is somewhat unsurprising considering that GOV was an ideal candidate for tax loss selling, given the magnitude of losses generated for many investors. A portion of the initial decline was warranted due to an unfavorable exchange ratio in the upcoming stock for stock merger with Select Income REIT (SIR) and a planned dividend reduction post-merger. However, it should be noted that the severity of the selloff has pushed GOV down to 63% below its 52-week high, which is particularly exceptional, considering that GOV was already trading at a large discount to NAV at its 52-week high. GOV is now staggeringly cheap for a REIT that has mostly government tenants with long-term triple net leases. GOV and SIR now trade at prices relative to one another that reflect the exchange rate of the upcoming merger. As a result, GOV and SIR have become the most attractively priced Office REITs with substantial upward potential coming out of tax loss selling season. It is important to note that the merger of SIR and GOV completed on 12/31/2018 and the new post-merger entity will be named Office Properties Income Trust and trade under a new ticker (OPI) beginning on January 2nd, 2019.
The two shopping center REITs with the biggest declines through October, Wheeler REIT (WHLR) and Cedar Realty Trust (CDR), were also the biggest victims of tax loss selling as their losses offered investors the opportunity to wash the greatest amount of capital gains. Wheeler holds the dubious honor of being the worst performer in the entire REIT sector during both periods of time, falling 67.1% during the first 10 months of 2018 and then declining another 72.6% between November 1 and December 24. Wheeler is facing numerous substantial challenges and has had to eliminate the common dividend and suspend the preferred dividends while it tries to right the ship. The magnitude of the selloff has sunk this struggling REIT down to a share price 92% below its 52-week high.
Not All Securities that Sold Off are Oversold
When a security declines substantially in price, this price movement could mean a few different things. It could be an accurate reflection of a change in value of the underlying assets or in future growth expectations, or an overreaction to bad news or an underreaction to news that justifies an even larger share price decline. Although the large share price declines that occurred earlier in the year were magnified by tax loss selling, it is important to consider to what degree each security was trading above or below fair value going into tax loss selling season. As a result, not every security that was impacted by tax loss selling represents a good investment. For this reason, it is important to pair the data in this article with an evaluation of the fair value of a security in order to determine if and to what extent a security is oversold. If the REIT sector experiences a healthy rebound in early 2019, these most oversold securities have the potential to achieve tremendous returns.
Although there was already rampant mispricing within the REIT sector, tax loss selling has further magnified the discounts of some heavily oversold REITs. This has created a wonderful opportunity to purchase these securities at a price far lower than they normally would (or should) be available. The table below includes what I believe to be the top 10 REIT opportunities post tax-loss selling to take advantage of this temporary mispricing. The table actually includes 11 REITs due to the fact that GOV and SIR will soon be merged into a single entity and the merged entity (OPI) can be attained by purchasing either security. These securities fell by between 10% and 43% during tax loss selling season and now trade at levels between 32% and 70% below their 52-week highs. These are certainly not the only great opportunities available in the REIT sector, but at current pricing I believe they offer the greatest potential upside.
*Update: Between the time I wrote this article and it was posted on Seeking Alpha, it was announced that MRT will be acquired by Omega Healthcare Investors (OHI). After rising substantially in price upon the acquisition announcement, MRT is no longer sufficiently discounted to remain a top opportunity at current pricing. Additionally, SIR and GOV have completed their merger and now trade under the ticker symbol OPI, which remains a very attractively priced opportunity.
Disclosure: I am/we are long APTS, CBL, FPI, GOV, MRT, SNR, PLYM, SIR, UMH, UNIT, WPG. 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: 2nd Market Capital and its affiliated accounts are long APTS, CBL, FPI, GOV, MRT, SNR, PLYM, SIR, UMH, UNIT and WPG. I am personally long CBL, MRT, SNR, PLYM, SIR, UMH, UNIT and WPG. This article is provided for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer. Information contained in this article is impersonal and not tailored to the investment needs of any particular person. It does not constitute a recommendation that any particular security or strategy is suitable for a specific person. Investing in publicly held securities is speculative and involves risk, including the possible loss of principal. The reader must determine whether any investment is suitable and accepts responsibility for their investment decisions. Simon Bowler is an investment advisor representative of 2MCAC, a Wisconsin registered investment advisor. Positive comments made by others should not be construed as an endorsement of the writer’s abilities as an investment advisor representative. Commentary may contain forward looking statements which are by definition uncertain. Actual results may differ materially from our forecasts or estimations, and 2MCAC and its affiliates cannot be held liable for the use of and reliance upon the opinions, estimates, forecasts and findings in this article.