A Look Inside Our Safe-Haven Portfolio: SRC.PA Is A Strong Buy
- As we transition into the new year, we are putting greater focus on "investment safety" to prepare our portfolio for the next market downturn.
- Our Safe-Haven Portfolio aims to deliver a stable 6-8% annual yield through preferred shares and other debt instruments that are backed by real assets.
- With more muted growth expectations, and less interest rate hikes on the horizon, we find great value in the high yielding preferred shares of soundly-financed REIT.
- The 6.6% yielding preferred shares of Spirit Realty Capital appear to be particularly safe and rewarding for this low risk profile.
- We are issuing a "buy alert" and adding it to our Safe-Haven portfolio.
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2019 marks the 11th year to an already-extended bull market which started in in the aftermath of the great financial crisis. It has been a long and very rewarding run for all investors… Especially REIT investors who have continued their long streak of market outperformance - returning over 1,700% since 1989:
Now, while this is all great, we should remain mindful that such gains cannot continue forever and that sooner or later, we will need to go through another recession with negative returns for stocks and REITs.
Historically, recessions occur on 5-10-year intervals when unemployment rates hit 4-5% figures:
- Today we are 10+ years into the cycle.
- Unemployment rate is at the lowest level in many decades.
What does this tell us?
We are likely to hit a recession sooner rather than later. We are not here to pointlessly scare you, but the data is not on the side of the market at this point any longer. We believe that the market still has 1-2 good years ahead of it and therefore, we are now taking the necessary steps to position ourselves accordingly before it is too late.
What are we doing about it?
At High Yield Landlord, we manage three real estate investment portfolios and we are currently in the process of making the following changes:
- 1) The "Core" Portfolio is our opportunistic real estate portfolio targeting maximum total returns with an ~8% on-going yield. It invests mostly in deeply discounted common shares of small cap value REITs.
In 2019, we will gradually shift more and more capital towards our safer investments such as Spirit Realty Capital (SRC) and W.P Carey (WPC). When presented with the right price, we will take gains off riskier positions and reallocate to safer companies. A recent example is the sale of our position in Sotherly Hotels (SOHO).
- 2) The "Safe-Haven" Portfolio is a senior real estate portfolio targeting a generous 6-8% yield with lower risk and volatility. This portfolio invests heavily in preferred shares and other debt instruments that are backed by real estate.
In 2019, we are increasing the amount of research on preferred shares and other debt instruments that are likely to sustain income and outperform in the next market downturn. Our allocation to this portfolio is expected to rise relative to the Core Portfolio as we prepare for a recession.
- 3) The "International" Portfolio is a Foreign real estate portfolio targeting diversification benefits from international property markets to boost risk-adjusted returns.
Diversification will play a key role in mitigating the risk of our portfolio as we hit the next recession. In 2019, we are increasing investments in Foreign markets with potentially less risky property markets and more favorable monetary policies.
Today's article is focused on (2) our Safe-Haven Portfolio, its strategy, and our latest Top Buy recommendation.
Safety and High-Yield in REIT Preferred Shares
Preferred shares combine features of debt, in that they pay fixed dividends, and equity, in that they have some appreciation potential. The details of each preferred shares depend on a case-by-case basis, but generally speaking:
- Preferred shareholders are senior to common shareholders when it comes to dividends. They are also senior when it comes to any liquidation proceeds, though they remain subordinate to bondholders.
- Many preferred shares have a "cumulative" feature which allows preferred holders to receive their dividend paid in-full before the common dividend can be resumed for other shareholders. Preferred shares may also have a "call" feature which allows the issuer to buy the shares back at par value.
- Because of these features, Preferred shares are less risky and tend to produce very consistent and safe income. On the flip side, they generally have less appreciation potential.
(Other features exist, but for simplification purposes we will focus on these ones.)
While Preferred shares can come in many shapes and forms, we believe that they are particularly attractive when combined with the REIT structure. This is because:
- REITs are, by nature, lower-risk real estate investment vehicles with large portfolios and sound balance sheets.
- They tend to produce highly consistent cash flow that is relatively defensive even in market downturns thanks to leases that protect the landlord.
- REITs must, by law, payout 90% of their net income in dividends to shareholders and are rarely liquidated.
The result is that even in a deep state of economic struggle, most REITs will continue to pay out their dividends to preferred shareholders. Common shareholders may take a dividend cut, but since REITs must pay 90% of their net income in dividends, they are very unlikely to ever fully eliminate the common dividend; and therefore the preferred is very safe.
Reminder: All preferred dividends must be paid before the common dividend, so for a REIT to pay even a tiny common dividend, it must first pay the preferred. It makes a cut very unlikely and even if it was temporarily suspended, it is likely to get paid later down the line before the common dividend is reinstated ("cumulative" feature).
Here is how REITs cut their dividends during the last recession:
As you can see the chart, common shareholders did take dividend cuts, but to the most part, preferred shareholders continued to earn high dividends throughout the crisis.
Recession-Resistant 6-8% Dividend Yield in REIT Preferred
As we scout for high yielding, yet safe preferred shares in the REIT market, we look for opportunities that combine the following features:
- A minimum 6% yield with cumulative feature.
- A share price that is below par to allow for upside potential if and when the shares are called back, the company gains a credit upgrade, and/or interest rates are lowered. A lower share price also reduces our downside risk.
- The underlying properties and balance sheet allow for stable cash flow with no major downside in a recession.
Our Safe Haven Portfolio is today well-diversified with 10 preferred shares and we are today making a new addition for added safety and potentially even greater future rewards.
Spirit Realty Capital Preferred Shares (NYSE:SRC.PA) Offer a Juicy 6.6% Yield With up to 10% Additional Upside
(Please Note: This article was published in late December when the shares were yielding 7.3%. Since then, the shares have appreciated by ~10% but we continue to hold our investment as we see further appreciation potential.)
Spirit Realty Capital (SRC) is no stranger to my regular followers. We have often covered the investment thesis for the common shares, and today, we taking our position one step further with some additional preferred shares.
SRC is a large net lease REIT with a portfolio of ~1,500 properties nationwide. It closely resembles Realty Income (O) which is the "gold-standard" of net lease investing. This is not be taken lightly because Realty Income has one of the best track records of the entire stock market with 16% annual returns for the past +20 years and 84 consecutive quarterly dividend increases, including the great financial crisis.
So the fact that SRC is similar to Realty Income is a very attractive trait. Just like Realty Income, we consider SRC to be a "low-risk" company because:
- The average remaining lease term is very long at ~10 years. The tenants are high-quality retailers such as Walgreens (WBA), Dollar General (DG), CVS (CVS), Circle K, BJ's (BJRI) and Home Depot (HD).
- The company is enjoying a 2-3x rent coverage with most tenants - meaning that the tenants would need to loose more than half of their profits before having troubles to pay rent.
- The leases include protections against inflation with automatically increasing rents and zero landlord responsibilities in most cases.
- The company uses little leverage and we expect a credit upgrade in the near future.
Special Features of The SRC Preferred Shares (SRC.PA)
- Par value vs. current price: The par value of the shares is $25, but the shares are currently sold on the cheap at just $22.84.
- Initial yield vs. current yield: The yield at origination was 6%, but bought at the currently discounted share price, the yield is a generous 6.6%.
- Cumulative shares: which means that common shareholders only get paid once all the preferred dividends have been paid. Callable: the shares are not callable until October 2022 - securing a high yield for close to 3 years.
Strong Risk-to-Reward for Conservative Investors
Attractive Reward Potential:
- 6.6% annual dividend yield with very unlikely cut.
- Additional ~10% upside is achievable through an anticipated credit upgrade (Positive Outlook), the eventual downward adjustment of interest rates, and/or once the shares get called back at $25 if and when SRC is able to reissue shares at a lower interest rates.
Mitigated Risk Profile:
- Lower risk assets with long lease terms provide very defensive cash flow.
- Low leverage, solid balance sheet, and outlook for credit upgrade
Preferred shareholders of Spirit Realty Capital are set for attractive returns with only limited risk. The 6.6% yield is very unlikely to ever be cut, not even in a deep recession. Added to that, the shares are likely to recover closer to par as the company finally earns its anticipated credit upgrade. Altogether, the shares are posed to return 8-10% annually in the next three years and there is very minimal risk of a dividend cut or permanent capital loss.
It is hard to find a better risk-to-reward outcome in today's marketplace. This looks pretty much as good as it can get for high-yield seeking conservative investors.
- As we approach the end of the current bull cycle, we will shift an increasing amount of capital towards safer real estate investments and this includes preferred shares of Quality REITs.
- Undervalued preferred shares of REITs offer a very strong risk-to-reward outcome because of the defensive nature of real estate investments and the senior position of preferred shares over common shares.
- SRC-PA pays a 6.6% yield that we expect to remain sustainable regardless of the broader economy.
- Moreover, it has up to 10% upside in the coming years as it earns a credit upgrade, interest rates are lowered, and/or the shares get called back.
- With minimal risk of principal loss and double digit return generation potential, we are bullish on the preferred shares of Spirit Realty Capital.
In many cases, preferred shares are pictured as the worst of both world with limited upside as compared to common shares, and limited protection compared to bondholders. In this particular case, we find the opposite to be true with sizable return potential for the present risk profile. This is afforded by the discount to par value, and the already upsized yield as compared to peers.
Note: We recently launched a 5-part series entitled "Best REITs to Own in Late Cycle" with members of High Yield Landlord in an effort to reduce risk ahead of the next market downturn. If you liked this report, please scroll up and click "Follow" next to my name to not miss future articles.
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This article was written by
Jussi Askola is a former private equity real estate investor with experience working for a +$250 million investment firm in Dallas, Texas; and performing property acquisition in Germany. Today, he is the author of "High Yield Landlord” - the #1 ranked real estate service on Seeking Alpha. Join us for a 2-week free trial and get access to all my highest conviction investment ideas. Click here to learn more!
Jussi is also the President of Leonberg Capital - a value-oriented investment boutique specializing in mispriced real estate securities often trading at high discounts to NAV and excessive yields. In addition to having passed all CFA exams, Jussi holds a BSc in Real Estate Finance from University Nürtingen-Geislingen (Germany) and a BSc in Property Management from University of South Wales (UK). He has authored award-winning academic papers on REIT investing, been featured on numerous financial media outlets, has over 50,000 followers on SeekingAlpha, and built relationships with many top REIT executives.
DISCLAIMER: Jussi Askola is not a Registered Investment Advisor or Financial Planner. The information in his articles and his comments on SeekingAlpha.com or elsewhere is provided for information purposes only. Do your own research or seek the advice of a qualified professional. You are responsible for your own investment decisions. High Yield Landlord is managed by Leonberg Capital.
Analyst’s Disclosure: I am/we are long SRC. 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.
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