Why REITs Will Outperform In 2019 - And Our Top Buy, Brookfield Property

Summary

• REITs have historically been one of the very best asset classes for high total returns with substantial income and only moderate risk relative to other asset classes.
• We believe that this track record of outperformance is the result of recurrent factors that are still here and expected to result in further outperformance in the long run.
• This is also supported by the strong fundamentals and discounted valuations. Moreover, we believe that the latest change in market leadership is set to improve market sentiment.
• REITs have proven time and time again that periods of underperformance are shortly followed by further outperformance. Will “this time be different”?
• We reveal in this report on Top Buy in the Property REIT sector today.
• Looking for a portfolio of ideas like this one? Members of High Dividend Opportunities get exclusive access to our model portfolio. Start your free trial today »

Co-produced with Jussi Askola and PendragonY for High Dividend Opportunities

It is well-known to the investment community that REITs have historically been one of the very best asset classes to invest in your hard-earned money. In the past 20 years, REITs have literally crushed the returns of every other sector with annual returns exceeding 12.5%:

source

If you remove the last 3 years of underperformance, the return differential is even greater, and the compounding effect works wonders. In the 10 years from 1997 to 2016, the Vanguard Property REIT ETF (VNQ) generated up to 4x higher total returns than the S&P 500 (SPY) and this is despite suffering the world’s sharpest real estate crash in 2008-2009:

source

Interestingly, REITs achieved these phenomenal results despite being less risky investments than most other stocks. This lower risk is the result of REIT’s underlying assets and the structure of their legal entity:

• REITs represent diversified portfolios of income-producing properties with long lease agreements and automatic rent increases to protect against inflation.
• Therefore, the assets are infrastructure-like and the cash flow is often more similar to a bond than an equity investment.
• REITs are inherently less risky investments and tend to be less volatile because the underlying value of properties acts as strong support against price fluctuations. At the end of the day, Property REITs own real estate properties, and real estate prices seldom fluctuate much, and in the long term, prices do appreciate.
• REITs pay higher dividends and are less reliant on more questionable growth to generate returns. REITs must by law pay out at least 90% of their taxable income – giving control of the cash flow over to the shareholders.

Whenever there is an opportunity to generate higher total returns with lesser potential risk, at High Dividend Opportunities it is our aim that our investors take advantage of such an opportunity. Our High-Quality Property REIT Portfolio has been constructed in order to participate in these superior results, and today, as we re-balance our portfolio for 2019, we take an updated look at the sector to assess its attractiveness going into the new year.

2019: The Big Year for REITs

Past results are never a guarantee of future performance. That said, we strongly believe that REITs are set for a strong return to outperformance in 2019 and beyond. This is simply because the factors which lead to outperformance in the past are still very much alive today. Moreover, the current pricing of REITs is historically cheap following a multi-year period of significant underperformance and the fundamentals remain strong.

Below we detail the three main reasons why we are convinced that REITs are set for outperformance and present an extract from our Top Pick in the sector.

#1 - Alpha-Rich Asset Class

Any asset class can outperform in one given year, but we believe that it is highly unlikely for an asset class to outperform over decades in a very repeatable manner without it having something truly special.

In the case of REITs, we refute the idea that their historical out-performance was a "one-time" exceptional event. This same argument has been made year after year and yet, REITs have always gotten back on top for almost half a century by now:

You simply do not outperform for a streak of 46 years by coincidence. We believe that REITs keep on outperforming stocks because:

1. Real estate is a superior investment asset class: a large portion of wealthy people on this planet have gotten rich (at least partly) through real estate. Centuries after centuries it has served as a vehicle to grow and preserve wealth. Properties generate consistent cash flow and appreciate over time as a result of a growing demand and supply imbalance for superior locations. It is hard for stocks to beat properties that produce high cash flow (8-12% levered cash-on-cash) along with a few percentage points of appreciation with only moderate risk.
2. REITs are tax-advantaged vehicles: adding to the alpha of real estate, Property REITs are tax-exempt vehicles – allowing them to save large cost in comparison to regular corporations (stocks). This alone may account to a 20% income advantage right off the bat. Assuming that two businesses are equally viable, but one is structured as a REIT and the other as a normal C-corp, the REIT will generate greater returns by simply saving massive amount of taxes.
3. REITs pay greater dividends: dividend paying stocks have historically greatly outperformed the non-dividend paying stocks. This is because dividends are the result of profitability which drive returns in the long run. The more dividends are paid, the safer the rewards, and the lesser risk there is that the manager wastes the profits on some lower-return investment. As such, REITs are designed to outperform given that they must, by law, pay out the majority of their income to shareholders.

The above three factors remain very relevant and result in mechanically repeatable outperformance. Therefore, as long as the valuation of REITs remains favorable, we have no doubt that REITs are set to continue beating markets in the long run.

#2 - Fundamentals and Pricing

The main drivers of returns in the stock markets are arguably fundamentals and pricing. Sectors with strong fundamentals relative to their pricing tend to outperform in the long run. This is simply due to their undervaluation relative to other pricier sectors.

Today, after a 3-year long period of significant underperformance, REITs have become relatively inexpensive compared to Stocks:

While stocks kept getting higher and higher on hopes for high-growth, REITs were left behind as “boring income” investments. This has resulted in discounted valuations and positioned REITs for stronger future performance.

• Priced on a Price/NAV: REITs are currently valued at about a 5-10% discount to "Net Asset Value" ('NAV') as compared to the sector’s long term historical average premium of 2-3%.
• Priced on a Price/FFO basis: REITs are valued at just around 16.5x "Funds from Operations" ('FFO') which is a full turn below their historical average.

So, while stocks are today priced on the expensive side relative to their long-term averages on hopes of continued growth in a late cycle economy; REITs are already priced cheaply based on pessimistic expectations.

Interestingly, despite the discounted valuations, the fundamentals of REITs remain very favorable.

• Balance sheets: are the strongest they have ever been after a decade of deleveraging. The " Loan to Value" ('LTV') ratio (or leverage) of REITs is at a low 35% on average (individual private real estate investors use closer to 60-80%), and most of this leverage is fixed rate with long maturities.
• Payout ratios: are also historically low at just around 70% of FFO on average. When combined with the strong balance sheets, it results in greater growth as retained cash flow is reinvested in more properties. It boosts price appreciation and increases safety.
• Property vacancies: are historically low and continue to trend even lower in most property sectors. It shows that most markets remain in check with little overbuilding risk and helps landlords target higher rent increases as tenants have little alternatives.
• Growth of cash flow: remains attractive with "Net Operating Income" ('NOI') growing at 2-3% in most property sectors and several REITs able to boost this with additional acquisitions financed with retained cash flow, portfolio recycling, and occasional capital raises.

Achieving a 5% growth rate is nothing unusual, and when you combine that with an already high dividend yield of 4% to 8%, your prospects for high returns are more favorable than most other stocks in our opinion.

In essence, most of our REIT picks are performing very well fundamentally. And yet they are priced inexpensively in today’s market. It puts the REIT market in a perfect spot to perform well in the times ahead as the market sentiment switches back in favor of REITs.

#3 - Change in Market Leadership Favors REITs

In the past years, REITs have been under pressure due to constant worries over interest rate hikes and a great preference for “high-growth” from the investment community. We have at many times debunked the claims that REITs are set to suffer from interest rates, but nonetheless the sentiment has remained challenged and kept the valuations low.

Today, we are finally seeing a reversal in sentiment because of the focus of the market is slowly switching from “rising interest rates” to “decelerating growth”:

• Lower growth: GDP growth will be trending lower and as a result, earnings growth will be decelerating in 2019. This isn’t too surprising considering the phenomenal earnings in 2018. We expect a gradual slow-down with lower growth in every quarter of 2019.
• Lesser interest rate hikes: With slower growth and lower inflation, the Fed will become increasingly cautious with further interest rate hikes. Currently the markets are pricing-in only one interest rate hike for 2019 (compared to four in 2018), and I would not be surprised if we see no rate hikes at all. If we look at the 10-year Treasury yield, it has pulled back from 3.2% to 2.7% meaning the markets are already factoring in lower inflation and lower interest rate expectations.

We believe that this change in market leadership will have a profound effect on the investment performance of different investment strategies. Investors will become less confident about future growth and will see greater value in high-yielding stocks with stable cash flow. This goes in favor of “Higher Dividend” stocks such as REITs and less so for “Growth” stocks, especially when we factor in the large valuation differential.

A Defensive Sector

Another strong point for Property REITs is that they are defensive in naturedue to the fact that their balance sheets consist of real estate assets, and that most operate under long term contacts. The stability of the sector's profitability and cash flows makes this sector more resilient to economic downturns. As investors become more defensive due to a slowing economic outlook, more funds will be allocated to this sector, thus supporting the prices higher. The beauty about this sector is that you get very generous yields while still investing in a mostly lower-risk sector.

Investor Take-away

Property REITs are among one of the most promising high-yield sectors we cover today at High Dividend Opportunities. REITs are priced inexpensively relative to their improved fundamental strengths and a shift in market sentiment appears to already be on its way. In the past 6 months as the broader market kept on dropping, REITs showed resilience as investors were relocating capital away from “high growth” to “higher income”.

Property REITs are naturally designed to outperform and after a 3-year long period of falling behind, we expect them to re-surge higher and get back on their lead against broader markets. One of our top picks in the REIT sector is already doing so, and we expect more to come in the coming quarters.

A 'High Dividend Opportunities' Top Pick Revealed

Just last December, we shared our Top Pick in the REIT sector for 2019 with members of High Dividend Opportunities ('HDO'). Since then, the rewards have already been very fruitful to investors who acted on our recommendation:

Nonetheless, even today at the higher price, Brookfield Property REIT (BPR) - and its sister company that is structured as an MLP Brookfield Property Partners L.P. (BPY) - still offer a great opportunity and we maintain our STRONG BUY rating. As a reminder, BPR and BPY offer a similar exposure except that BPR is structured as a Property REIT, while BPY is structured as a Master Limited Partnership ('MLP').

Below are the top 7 reasons why we remain bullish in BPR even more now despite the recent gains:

(greater investment research and discussion on BPR and BPY is available at High Dividend Opportunities)

1. BPR is a blue-chip real estate investment company with a premier class A portfolio of assets. It has one of the best management teams in the world and an investment grade credit rating.
2. The FFO is expected to keep on growing at a rate of 7-9% per year by means of NOI growth and development projects coming online.
3. Insiders are buying: The management is the largest owner of the shares and they are today making aggressive additions to their position while the shares are offered on the cheap.
4. Despite its high-quality attributes, the company is priced at just around 10x FFO, a deep 30% discount to NAV and an even larger discount to peers. The valuation looks very cheap from every perspective, and closing the gap to a conservative fair value would result in 40% upside.
5. While we wait for the upside case to play out, the company is paying a safe forward dividend yield of 7% that enjoys a very high coverage. The dividend is expected to keep on growing in the coming years at about 5% per year.
6. BPR just reported their Q4 earnings and they were stellar! The office portfolio delivered 5% NOI growth on a same store basis. The retail portfolio increased its NOI-weighted sales per square foot by 6% and earned leasing spreads of up to 11% on average.
7. Most importantly, BPR just hiked once again, this time by 5%. A very nice pay raise for income investors to start the year 2019.

With high yield, high growth, and high upside combined together, it is hard to beat the reward potential of BPR, especially when you consider that the company owns Class A assets, is managed by a top team, and there are large insider BUYS in place.

Conclusive Remarks and Food for Thoughts

To end this thesis on a strong note, we wanted to still share a final chart just as food for thoughts to the bears.

Over their +30-year long track record, REITs have suffered hundreds of sell-offs varying in intensity and duration; and yet they have always eventually recovered to new highs and outperformed stocks and bonds by a wide margin:

Will this time be different? We do not believe so. This rally is just getting started. Now it is one of the best times to buy Property REITs to lock in the generous yields still offered, and achieve long term capital gains. While the REIT sector has lagged the markets during the past 3 years, history will repeat itself, and this sector will be the market leader for many years to come. Again, the beauty about investing in Property REITs is that you get very generous yields while still investing in a mostly lower-risk sector.

Analyst’s Disclosure: I am/we are long BPR. 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.