The More It Drops, The More I Buy - Revisited

by: Jussi Askola

Once again, REITs recovered the majority of their losses after a painful end of the year 2018.

Historical data suggest that REITs will keep outperformance even in times of increasing interest rates.

Fundamentals are strong today with REITs enjoying solid NOI growth and historically strong balance sheets.

We share 3 Top Holdings of our “Core Portfolio" at High Yield Landlord.

I hate to say it but "I told you so"...

When REITs sell off due to interest rate fears, it is time to load up on them. It is now the 5th time that we make this same call on Seeking Alpha (with always the same article title) and each time the results have been same:

REITs sell off leading to interest rate hikes, and quickly recover their losses thereafter.

Recognizing this pattern has allowed us to profit from the excessive volatility by buying the repetitive drops and reselling just a few months later for a quick profit.

Most recently, we encouraged members to buy the drop in December when REITs sold-off due to interest rate fears. We loaded on up on numerous of our top picks and we are today sitting on some nice gains:

Earlier in in 2018, we were offered the exact same opportunity as REIT sold off in February due to interest rate fears and quickly recovered thereafter:

Why are these sell-offs so profitable?

The simple answer is because investors act irrationally. They spend a lot of time worrying about interest rate hikes when it comes to REIT, but much less so figuring why this should be an issue in the first place. The common wisdom of the market is to avoid REITs in times of rising interest rates as it may result in higher borrowing cost and lower NAVs.

Yet, when studying market history as well as current fundamentals, we find no evidence to justify this reasoning; opposite of that we find plenty of evidence that REITs may perform very well in times of rising interest rates. The truth is that most REITs are unaffected by interest rate hikes to the most part, and therefore, when the market gives us the opportunity to buy low; we gladly take the offer.

Buy Low/Sell High - REIT Edition

Historical data shows that buying REITs right after a sell-off is very likely to result is strong future outperformance. REITs have over their multi-decade history suffered hundreds of sell-offs varying in intensity and duration; and yet they have always eventually recovered to new highs and outperformed broader equity markets.

Source: NAREIT

This is especially true when the sell-off is due to interest rate fears. Contrary to popular beliefs, objective research actually shows that REITs perform well in times of rising interest rate. As a matter of fact, REITs (VNQ) have even outperformed the S&P 500 (SPY) in more than half of the episodes of rising treasury yields since 1992. In 87% of the episodes of rising rates, REITs generated positive total returns during this same time frame. While it may surprise many of you, it really shouldn't:

  1. Interest rate hikes are generally the result of strong economic growth and inflation - which are both bullish for REITs and real estate in general.
  2. Higher economic growth allows REITs to hike rents and achieve higher occupancy.
  3. Higher inflation has historically led to higher property values over time.

Taking these factors into account, we are happy buyers of REITs whenever investors become concerned about interest rate hikes. The volatile market sentiment may influence pricing over the short run, but fundamentals trump pricing in the long run.

Strongest Balance Sheets Ever… and High NOI Growth…

Today, the fundamentals of the REIT market are particularly favorable to sustain interest rate hikes as leverage is at an all-time-low and NOI is growing at a fast pace.


REITs have steadily fortified their balance sheets since the great financial crisis - leaving the industry in a financial position it has ever seen before. The leverage levels are very reasonable today with the average debt-to-assets at just ~35% - which compares very favorably to the many private equity real estate investors who often use up to 70% debt to finance deals. Moreover, it should be noted that most of this debt is long-term fixed-rate, and as such, the exposure to interest rate movements is minimal today.

While the balance sheets are stronger than ever before, NAREIT notes that REITs are achieving fast growth today with increasing rents and occupancies.

Current operating performance for the REIT industry is right in its "sweet spot": over the last four quarters, same-property NOI growth averaged 3.2 percent, consistent with the industry's long-term norm. Same property NOI growth greater than about 4 percent can be "too much of a good thing," stimulating so much new construction that it results in oversupply that reduces occupancy rates and rents, eventually suppressing same-property NOI growth to its "soft" range of 2.5 percent or less.

Therefore, we conclude that the operating environment of REITs remain solid and promising, even if rates continue to increase (which is far from being a certainty...)

In this sense, our "buy low - sell high" approach to buying REIT market dips continues to apply in 2019. In fact, we would go as far as to say that we hope REITs would suffer another sell-off. We have fresh capital to invest, and finding new opportunities is getting harder and harder as prices keep climbing up. Back in late December, this was very easy as literally every REIT was on sale including the highest quality names such as STORE Capital (STOR), Realty Income (O), Kimco (KIM), Welltower (WELL), Simon (SPG) and Prologis (PLD).

Today, REITs remain underpriced relative to most other asset classes, but the magnitude of the discount has come down significantly. With this in mind, let's have a look at where we currently see the best opportunities.

What Are We Buying Today?

Not every REIT sold off to the same extent in late 2018, and not every REIT recovered its losses in the same fashion either. Studying fundamentals in relation with valuations, we consider the 3 following REITs to remain highly opportunities today:

Iron Mountain (IRM) is a niche player in the storage industry focusing on business clients rather than consumers. Instead of renting place to Jack so he can store his jet ski, IRM leases space for Coca-Cola (KO) to store its mountains of paper records. IRM enjoys a strong moat in the sector as the leader providing space to 95% of Fortune 1000 companies. Compared to self-storage, the demand and supply dynamics appear more favorable relative to the pricing of assets today - making IRM more opportunistic compared to Public Storage (PSA) like companies. The dividend yield is closed to 7% and expected to grow by 4% in 2019.

Jernigan Capital (JCAP) is a relatively new REIT that provides creative capital solutions to private developers, owners, and operators of self-storage facilities. It is a model that is different from equity REITs, but also from mortgage REITs. In many ways, it gets closer to a business development firm (BDC) as it loans money, receives equity and often provide additional services to their borrowers. The results have been phenomenal thus far with very strong returns on invested capital, and the pipeline remains large. Sold at just about 7.5x FFO and a well-covered 6.5% yield, we consider the risk premiums to be excessive and we are happy to take the risk on this one.

Brixmor Property Group (BRX) is a grocery store-anchored shopping center REIT that is undergoing temporary dilution caused by property dispositions, redevelopments and key tenants. In the long run, the assets owned by Brixmor deserve a substantially higher valuation multiple than 9.2x FFO. Unlike the market, we see very minimal obsolescence risk in grocery store retailing. Amazon (AMZN) may cause great pain to some sectors, but this is one of them that we expect to sustain strong profits in the long run. The NOI growth has already turned positive and the company pays a well-covered 6.4% dividend yield.

In addition to these 3 Top Picks, we currently hold 18 other undervalued REITs in our Core Portfolio. In our last article of this same series, we suggested that Brookfield Property REIT (BPR), UMH Properties (UMH) and Spirit Realty Capital (SRC) were solid opportunities. Here are the results three months later:

Final Thoughts

The main reason why we like real estate and REITs so much is because at the end of the day, we are not smart enough to predict what will happen to Bitcoin (COIN), Facebook (FB) or even Netflix (NFLX) in the long run. We know however that quality real estate bought on the cheap is a strategy that is expected to result in favorable performance. In this sense, rather than trying to pick the new "high grow" "high tech" investment, we stick to what we know and understand best: real estate.

By putting our full-focus on this one niche market and hand-picking the most undervalued small-cap value REITs, we believe that we have the potential to outperform broader equity markets, not to mention, most other REIT investors.

Disclosure: I am/we are long BPR; UMH; SRC; BRX; JCAP; IRM. 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.