Building A Recession-Resistant REIT Portfolio

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Includes: HTA, ROIC, STAG, WPC
by: Brad Thomas
Summary

By September 2020, we could be in a recession. Underline “could."

Considering how badly REITs got hit in 2007-2009, it’s understandable real estate investors might want to run for the hills at the first sign of danger.

Recession or not, those balance sheets spell good news at best, and significant levels of safety at worst, for antsy investors.

A recession is coming. And that means you want and need to add some recession-resistant REITs (real estate investment trusts) to your portfolio.

When is this recession coming? More than likely, it won’t be in the next couple of months. Not when jobs growth in January was so “strikingly robust,” as Politico reported, adding an impressive 304,000 jobs.

And that was despite the government shutdown that dragged through most of the month.

However, those results are only for the first month. We’re still in the first quarter. For the full year, analysts expect U.S. economic growth to slow significantly – a trend they don’t see stopping after 2019 is over.

By September 2020, we could be in a recession. Underline “could.”

Recessions come and recessions go, of course. But some of them leave noticeable scars on particular sectors. For instance, the Great Recession and REITs.

Considering how badly REITs got hit in 2007-2009, it’s understandable real estate investors might want to run for the hills at the first sign of danger.

Understandable, but not advised. You’re really better off not acting on those inclinations… and instead, taking these four recession-resistant REITs below into serious consideration.

A Quick but Accurate Assessment of the Great Recession

Why am I so confident in these recession-resistant REITs? To understand that, you have to first understand what happened to the larger sector during the Great Recession.

It’s true REITs were the worst-performing sector in 2007. And the third-worst in 2008… hardly the most inviting calling cards to hand out, I’ll admit.

But that was due to a very specific set of circumstances. Namely, how most of the credit markets they’d been swimming in for five or six years were suddenly frozen solid, with no wiggle room left.

It’s hard to be too critical. One must remember, at the time, this financial collapse was paralleled only by the Great Depression and saw the end of Lehman Brothers and Bear Sterns and the near collapse of Citigroup (NYSE:C) and AIG (NYSE:AIG). Yes, financial markets were in utter turmoil, and there was no certainty any REIT would have access to capital.

Yet, to some degree, it was their own fault. Most all financial sectors (REITs included) took on too much in the hyper-good times and paid the literal price in the extreme bad times that followed.

To their credit, most of them took that painful correction to heart, leaving the sector standing much stronger today. According to NAREIT (in December), REIT balance sheets were looking good. Very, very good.

Despite two corrections in 2018, a trade war escalation, the Fed hiking short-term rates a total of four times, and growing fears of an coming recession… REITs were still able to raise equity capital a total of 110 times, amounting to $41.84 billion.

Recession or not, those balance sheets spell good news at best, and significant levels of safety at worst, for antsy investors.

Photo Source

Safety, Predictability and Profit

To be clear, there are plenty of recession-resistant REITs out there to be had. Most of them tend to go up during downturns, as evidenced by the data I reported in my on-the-money, in-the-money newsletter, earlier this month.

Let’s just say the charts look good.

Since 1972, REITs have shown positive total returns 75% of the time in recession-bearing years, rising an average of 6.2%, all told.

They’re safe. And most people crave safety at times like those.

That’s a level of predictability well worth taking advantage of, by getting into recession-resistant REITs right now.

Not just any recession-resistant REITs either. We’re taking no chances here, only looking at the best of the best: Battle-tested investment entities with extremely impressive track records and balance sheets so tight you could bounce a quarter off them.

These REITs know what they’re doing, as evidenced by the stats they sport.

In November 2018, we built an all-new Recession-Ready REIT Portfolio that included 20 REITs. In January 2019, the portfolio returned +8.8% with top picks: Kimco (NYSE:KIM) (+17.8%), Tanger Factory Outlet (NYSE:SKT) (+15.9%), W.P. Carey WPC (+13%), and STAG Industrial (NYSE:STAG) (+11.8%). Here are the January 2019 top 10 REITs (based on total return):

In a moment, we’ll look closely at a handful of REITs worth considering. As of mid-week, though, here’s how the entire portfolio was doing:

Source: Rhino Real Estate Advisors

4 Favorite Recession-Ready REITs

W.P. Carey is a net lease REIT that invests in free-standing office, industrial, retail, and other properties. The company generates attractive risk-adjusted returns by identifying and investing in net-lease assets in which the company seeks to acquire “mission-critical” assets essential to a tenant’s operations. The company creates upside through lease escalations (approximately 99% of leases have contractual rent increases, including 65% linked to CPI), credit improvements and real estate appreciation. The hallmark of this approach is rooted in diversification by tenant (1,186 properties), industry, property type and geography (WPC remains well diversified with 62% of ABR generated by properties across the U.S., and 35% from properties in Europe).

On Oct. 31, 2018, W.P. Carey closed on the merger with CPA:17 ahead of schedule, increasing the company's market cap to ~$11 billion and the enterprise value to a little over ~$17 billion, making the company one of the largest REITs. This transaction further strengthens W.P. Carey’s credit profile with earnings from real estate covering a much larger percentage of interest expense and dividends, as well as having the deleveraging impact on the “consolidated debt to grow assets” basis.

W.P. Carey has a clear path to bring that back down by replacing mortgage debt with unsecured debt as it has done since embarking on an unsecured debt strategy in 2014 (WPC is rated BBB by S&P). The company continues to have access to multiple forms of capital and now has ample liquidity with more than $1 billion of capacity on its revolving credit facility. The company has managed through multiple recessions and has never stopped growing its dividend – in December the company increased its quarterly cash dividend to $1.03 per share and continued the track of 18 years of consecutive annual dividend increases. So, when the next recession strikes, W.P. Carey appears to be well positioned. Maintaining buy.

Source: F.A.S.T. Graphs

STAG Industrial, which stands for “Single Tenant Acquisition Group,” is an industrial REIT that seeks to acquire individual, single-tenant industrial properties that are priced according to the binary nature of their cash flows. One primary differentiator for this company is that unlike most peers, the company focuses on secondary markets. This acquisition strategy is unique in that the cash flows are diversified in such a way that the company is able to mitigate the risk and enhance the stability of the dividend income derived from the stable and diversified portfolio.

Closer to (my) home, STAG has around 4.8% exposure in Greenville/Spartanburg, and that’s also where BMW operates its North American manufacturing plant. A few days ago, BMW said it’s planning to produce (in April 2019) its new X3 M and X4 M cars (hi-po SUVs). According to Motor1.com, “the cheapest version money will buy is going to be the xDrive40i at $60,700, which is only $1,200 more than the old 2018 X5 xDrive35i.”

That’s not only great news for my hometown, but also for STAG investors, since the company has a fleet of warehouses leased to BMW suppliers. But it’s not just that STAG has been successful in Greenville/Spartanburg, but in the latest quarter (Q4-18), the company achieved an impressive 81% retention (83% for the year). Also, cash and GAAP leasing spreads were 8% and 16% for the quarter and 8% and 15% for the year, respectively.

Fueling STAG’s growth is a stronger balance sheet that remains defensively positioned with ample liquidity (of $577 million). The second investment grade rating by Moody's allowed STAG to reduce interest expense by approximately $2 million per year in 2018. STAG expects acquisition volume between $650 million and $800 million in the aggregate for 2019. FFO (funds from operations) for Q4-18 was $0.46, and $1.79 for the year, an increase of 5.3% compared to 2017. STAG increased its common dividend to $1.43 annually. The company has increased its dividend every year since the IPO in 2011.

Although STAG is exposed to secondary market risk, we view that as a competitive advantage, and we are maintaining a buy.

Source: F.A.S.T. Graphs

Retail Opportunity Investments (ROIC) is a solid recession-ready pick, as the company invests in some of the most affluent markets in the U.S.: Seattle, Portland, San Francisco, Sacramento, Los Angeles, Orange County, and San Diego. These top-tier markets enjoy above-average household income levels and disposable income to support the retail investment model. Over the years, the company shifted its focus toward stabilized, high-quality, well-located, grocery-anchored shopping centers, where the company builds value through increasing occupancy and rents as leases roll over.

In Q3 2018, ROIC achieved a new record-high portfolio lease rate at a very strong 97.8%. The company executed more than 100 leases during the quarter with a good mix of new and renewed activity, while also achieving solid rent growth (the company executed 48 leases totaling 139,000 square feet achieving a 17.1% increase in same space comparative cash base rent on average).

ROIC also maintains an exceptionally strong balance sheet, and secured debt is now down to less than $90 million (encumbering just four properties). During Q3-18 ROIC lowered its line of credit balance by $55 million (down to $137 million outstanding), and interest coverage increased to 3.3x.

In terms of FFO, ROIC had approximately $106 million in total FFO, or $0.85 per diluted share, for the first nine months of 2018, and the FFO guidance range for the year is now $1.13 to $1.15. In terms of same center NOI (net operating income), ROIC expects the year-over-year increase between 2.5% and 3%. We are maintaining our strong buy recommendation on ROIC.

Source: F.A.S.T. Graphs

Healthcare Trust of America (HTA) is the largest “pure play” medical office building REIT and has evolved into a “sleep well at night” enterprise. A little over a year ago, the company closed on the acquisition of the $2.7 billion Duke Realty (DRE) MOB (medical office building) portfolio, with an annualized NOI of $147.6 million and 5.4% yield. That was a transformation deal for HTA and one that added integration risk.

Yet, HTA has since proven it can successfully integrate, and the company is now back in the acquisition business, seeking to grow externally in 2019, with $175 million of net acquisitions. This growth is reinforced by HTA’s improved cost of capital and stronger balance sheet. During 2018, HTA paid down approximately $241 million in outstanding secured mortgage loans, including the settlement of three cash flow hedges. Additionally, in August 2018, HTA modified its $200.0 million unsecured term loan, decreasing pricing at HTA's current credit rating by 65 basis points and extending the maturity to 2024.

HTA ended 2018 with total liquidity of $1.1 billion, inclusive of $126.2 million of cash and cash equivalents, resulting in total leverage of (i) 31.3%, measured as debt less cash and cash equivalents to total capitalization, and (ii) 5.4x, measured as debt less cash and cash equivalents to adjusted EBITDA. Also, on Feb. 14, HTA's Board of Directors announced a quarterly cash dividend of $0.310 per share of common stock.

In 2018, HTA’s FFO, as defined by NAREIT, was $335.6 million, or $1.60 per diluted share, an increase of $0.07 per diluted share, compared to 2017, and normalized FAD (funds available for distribution) was $285.3 million, an increase of 9.4%, compared to 2017.

The company expects 2019 guidance for normalized FFO per share between $1.62 and $1.67. We like HTA’s valuation today that supports our strong buy rationale.

Source: F.A.S.T. Graphs

Author's note: Brad Thomas is a Wall Street writer, and that means he is not always right with his predictions or recommendations. That also applies to his grammar. Please excuse any typos and be assured that he will do his best to correct any errors if they are overlooked.

Disclosure: I am/we are long HTA, ROIC, WPC, STAG. 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.