Dividend Aristocrats are “blue-chip” companies that have managed to raise their dividend for at least 25 years in a row. They have historically outperformed broader equity markets by a rather wide margin. In the past 10 years, the Dividend Aristocrats generated total returns of 12% per year, compared with 9% for the S&P 500 (SPY) index:
The reason for this outperformance is straightforward: Dividend aristocrats tend to enjoy superior fundamentals in combination with:
- Predictable and consistent pricing power
- Lower earnings volatility
- Strong market positioning
- Competitive advantage
- Moated business model
These are all excellent businesses with high margins, valuable brands, and sustainable competitive advantages - allowing them to keep on hiking their dividends.
- But what is the one negative thing that most of these dividend aristocrats have in common?
They trade at relatively pricey valuations and they pay low dividend yields. As such, despite being great companies, this may not always translate to being great stocks if the market has already bid up share prices.
Put differently, we find it increasingly difficult to find “value” in the widely popular "dividend aristocrat" sub-sector.
- What if we could find stocks with similar fundamental traits that offered at a deeply discounted valuation and high dividend yields?
Since most dividend aristocrats appear to be expensive today, we lower our standards to companies that have managed to hike their dividend for at least 8 years in a row and have the potential to someday officially become dividend aristocrats.
To be more specific, at High Yield Landlord, we look for companies that enjoy:
- Sustainable and growing cash flow protected by long contracts.
- Have the potential to hike dividends by 4% per year.
- Profitable enough to pay-out a ~6% dividend yield per year.
- Solid track record that gives confidence for the future.
Where Are the Bargains in 2019?
As we head into February of 2019, we continue to find the most opportunities in the REIT sector that missed out on most of the gains in the recent years:
Due to the recent period of underperformance, REITs have become increasingly cheap today with many quality names trading at their lowest valuations in years. Regardless of what valuation metrics you look at, all the evidence points out that REITs are the place to be in 2019:
- Low FFO Multiple: REIT valuation multiples have fallen to just around 16.5x which is historically inexpensive in a low interest rate environment.
- Discount to NAV: REITs are substantially undervalued at a ~5-10% average discount, compared to a 2-3% long-term average premium.
- High Dividend Yield: Many top performers yield well over 5% today in comparison to the low 1.9% of the S&P 500.
- Strong Fundamentals: Cash flow and dividends keep on growing at a healthy pace and leverage is at an all-time-low.
- Track record of Outperformance: Over long time periods, REITs have outperformed most other sectors; and this is especially true after a long period of underperformance with cheap valuations.
We have no idea where the REIT market is headed in the near term, but this is irrelevant to long term-oriented investors. In the long run, we feel confident that our approach of buying quality REITs when they are on SALE will yield good investment results.
Three High Yielding Bargains in an Opportunistic Sector
Every sector contains relatively cheap, expensive, and moderately valued securities - REITs are no exception. Our Core REIT Portfolio is today paying out a sustainable ~8% dividend yield that is safely covered by cash flow with a low 70% payout ratio.
Below we outline the Buy Theses of 3 “Blue-Chip” REITs that we own heading into 2019.
1 - W.P Carey (NYSE: WPC): International Net Lease Opportunity 5.7% Yield / 13.5x FFO
WPC is a blue-chip REIT with a significant track record of market outperformance trading at only 13.5 times its FFO.
- It is a very well managed REIT with an attractive portfolio of net lease properties that is well diversified across geography, property type and tenant. Its 5.7% dividend yield is safe with a conservative 75% FFO payout ratio. WPC has a long 18-year track record history of dividend increases. During the last 10 years, the dividend per share more than doubled with no interruptions in annual dividend hikes.
- WPC is trading at a much smaller cash flow multiple relative to many of its peers due to two main reasons: firstly, the REIT also operates an asset management business which adds business complexity. And secondly, about 30% of their portfolio is located in Europe.
- We, however, consider both attributes highly attractive. The asset management platform allows WPC to grow faster and access more capital as they launch new non-traded REITs and other vehicles. Moreover, with the recent merger of CPA-17, the asset management business is expected to decline to historically low levels – making WPC more comparable with other net lease REITs.
- We do not see the international exposure as a liability either. It allows US REIT investors to access the European real estate market without the negative implications of withholding taxes and higher transaction cost. It also permits WPC to look for opportunities in a larger universe of net lease properties.
- The future growth prospects look very compelling considering that the REIT is already yielding over 5.7%. With steady annual dividend hikes, we expect WPC to continue its long streak of outperformance far into the future.
WPC’s Dividend Track Record:
Conclusion: WPC is essentially a REIT with above average attributes selling at a below average price. It has a phenomenal track record and is getting close to becoming a dividend aristocrat. Yet, the company is sold at a sizable discount to broader REIT markets at just 13.5x FFO and a 5.7% yield for reasons that we believe to be unjustified.
2 - EPR Properties (EPR): Specialty Assets with High Yield and Growth / 12x FFO / 6.2% Yield
- EPR is a net lease REIT, specializing in select real estate segments that are highly enduring, but often ignored by the investment community. The focus is to put on "experience"-based properties such as movie theaters, water parks, golf complexes, ski areas, schools and other.
- This differentiated investment strategy has resulted in very significant outperformance in the past. Since its origination about 20 years ago, EPR shareholders have earned a lifetime total return that is about 3x higher than the broad REIT indexes (NYSEARCA: VNQ). While I do not expect such massive outperformance to continue, I believe that the current valuation, combined with the growth prospects, allows for continued excess returns.
- Entertainment properties are not negatively affected by Amazon-like (NASDAQ:AMZN) companies. Moreover, they commonly sell at above-average cap rates, allowing EPR to earn sizable spreads over its cost of capital. It has historically resulted in superior external growth which combined with 2-3% internal growth rate has made this REIT a winner in the past.
- "Growth REITs" should rightfully sell at "growth valuations". Yet, EPR trades at just 12 times FFO and a 6.2% dividend yield. We consider this cheap on an absolute basis, but also on a relative basis. Peers including Realty Income (NYSE: O), National (NYSE: NNN), Agree (NYSE: ADC), STORE (NYSE: STOR) and Four Corners (NYSE: FCPT) all trading at large premiums at up to 15-20 times expected FFO. The valuation gap is very large here and not justified especially when you consider that peers may be more exposed to retail risk.
- The current dividend yield of 6.2% combined with mid-single-digit FFO growth rates make EPR a top pick among net lease REITs.
EPR’s Dividend Track Record:
Conclusion: We suggest that great achievers such as EPR should be valued based more on their growth capabilities rather than their "Net Asset Value" (or NAV). The company has consistently hiked its dividend yield for 20 years, with only one hiccup during the great financial crisis which was short lasted. With attractive yield, consistent growth, and discounted valuation, we anticipate EPR to remain an outperformer in the long run.
3 - Iron Mountain (IRM): Market-Leading Storage Operator / 13x AFFO / 6.6% Yield
- The storage industry can be divided into two main segments: consumer and business. While most of today's REITs, including Public Storage (PSA), Extra Space (EXR) and CubeSmart (CUBE), focus on the consumer side, IRM has always remained centered on business customers. Instead of renting space to Jack so he can store his jet ski, IRM leases space to Coca-Cola (KO) to store its mountains of paper records.
- We prefer this approach in today's market, especially when considering the relatively elevated valuations of consumer self-storage REITs as compared to IRM.
- IRM enjoys a strong moat as the leader of the sector - providing space to 95% of Fortune 1000 companies and while the developed markets are getting saturated, IRM has the opportunity to build on its customer relationships and trust to leverage its brand internationally. Emerging markets are growing fast and IRM is today capitalizing on the growing demand for storage in many new markets.
- IRM remains one of the few storage REITs trading at below average valuations, despite its market leading positioning, differentiated business model and long-term track record of value creation.
- We believe IRM may have been overlooked as it only became a REIT three years ago. Yet, when looking deeper into the fundamentals, we find a solid business model with a good shot at generating mid-single-digit growth over the long run - sold at a hefty 6.6% yield.
IRM’s Dividend Track Record:
Conclusion: IRM is not a "cutting-edge" high-tech firm, but lots of businesses need their services and this is the type of simple and clear-cut business that we like to own. It produces predictable and growing cash flow that is supported by a solid business plan and a defensive market positioning. In addition, it also pays a significant dividend yield that is expected to keep on growing into the future.
Buying high-quality businesses paying out high and growing dividends is our main objective at High Yield Landlord. The REIT market is today offering numerous opportunities as the market remains excessively pessimistic. Yet, the fundamentals remain overwhelmingly positive with growing cash flow and historically strong balance sheets.
We believe that high-quality real estate bought on the cheap is simple but particularly powerful investment strategy. With an overweight to quality companies, we are confident that our Core Portfolio and its ~8% average dividend yield is set to reward us handsomely in the coming years.
Note: We are currently sharing the full list of our REIT investments with "High Yield Landlord" members along with a report entitled "Our Favorite Picks for 2019".
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Disclosure: I am/we are long EPR; 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.