REITs Vs. Stocks: Which Is Riskier In 2019?

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Includes: NNN, O, PSA, SPY, VTR, WPC
by: Jussi Askola
Summary

High-flying growth stocks have ruled the headlines in recent years during the current economic expansion.

As economic expectations dim, investors position their portfolio toward more conservative investments.

We identify five factors why REITs are safer investments than stocks in 2019.

We also outline our approach to REIT investing in a late-cycle economy.

2019 marks the 11th year to an already-extended bull market which started 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-plus into the cycle.
  • The 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. Interest rates are peaking and global economic growth is slowing down. We may not be at risk of an imminent recession, but we are getting closer to it, and therefore, now is the time to prepare for it.

What to do about it?

The most important is to position your portfolio toward more conservative investments.

A question that we get often is which asset class do we consider to be the riskiest: REITs or stocks? This question is especially interesting today as we approach the next down cycle.

Spoiler alert: REITs are much safer in our opinion. Below we explain the five reasons why, and then dive into which REITs are the best positioned to deliver solid returns in 2019 and beyond.

Businesses come and go… Real estate is here to stay…

While businesses (stocks) come and go, well-located properties (REITs) are here to stay, with landlords cashing rent check after rent check regardless of occasional tenant bankruptcies and/or ups and downs of the market.

Most businesses are more volatile than you would like to admit. They operate in rapidly-changing markets and commonly have little protection in place against new innovations, disruptions, or competitors that could cause significant harm to their businesses. We have seen it time and time again where a highly successful company with a market-leading position would lose it all because of a new innovation that caused their product to become obsolete. As a Finnish citizen, the first example that comes to my mind is Nokia (NOK) which at one point controlled more than 40% of the mobile phone market share just to a few years later lose most of it to Apple (AAPL) and Samsung (OTC:SSNLF). It goes without saying that shareholders suffered enormous losses and that this is just one example among many others.

Compare this to a well-located property that's leased to a tenant. The landlord is in a much safer position because of five key reasons:

  1. Each property has a moat in its unique location and technology is having much lesser disruption than in other sectors.
  2. Landlords participate in the profit earned by their tenants through rents that are contractually guaranteed - often for many years to come.
  3. Landlords get paid first. Without a rent payment, a business cannot keep operating and therefore rents are even senior to debt payments in most cases.
  4. In the worst case where a tenant goes bankrupt, landlords can simply release the same property to another tenant. The value of the previous tenant's business may go to zero, but the landlord is in a much stronger position to sustain value.
  5. As a scarce supply and essential part of our infrastructure, real estate will always remain valuable.

Put simply, landlords participate in the underlying returns of businesses with much lesser risk on average.

REITs Generate More Resilient Cash Flow

As we explain above: Landlords participate in the profit earned by their tenants through rents that are contractually guaranteed - often for many years to come.

It protects property owners from changing market conditions, and therefore, it's common for property earnings to lag the general economy with lesser volatility over the full market cycle. This is especially true for REITs as they own highly diversified portfolios with 100s or 1000s of leases. Consider this: In the sharpest real estate market crash of mankind, the same store NOI of REITs dropped by just around 2% as most tenants continued to pay pre-agreed rents in full and on time:

Source

On the other hand, a regular business will typically feel the impact of a recession long before the average property owner. Take the example of a manufacturing company that may see its order book cut in half from one year to the next - and see its profit plummet along with it.

REITs Have Historically Been Less Volatile

Because of the more resilient cash flow, REITs also tend to be less volatile than other stocks in more time periods. The Beta, a measure of systematic risk, affirms this point as the beta of US REITs (relative to the U.S stock market) has during most time periods been significantly below 1, meaning that the asset class experienced less volatility than the overall U.S Stock Index.

Source

Despite periodically suffering from the higher volatility of financial markets over the short run, REITs follow the real estate market over the long run. There's less risk of big negative surprises as earnings are more stable and the higher dividend payment often acts as a protection against the daily market fluctuation of the stock market.

In an interview with NAREIT in 2014, Glenn Mueller, professor at the University of Denver, noted that the normalized volatility of REITs is about 30% to 40% of the overall stock market and they are hence low-volatility investments.

REITs Rely on Dividend… Stocks Rely on Growth…

In an environment of slowing growth and peaking interest rates, we much rather generate our returns form dividend income rather than more uncertain capital appreciation.

REITs tend to pay much greater dividends than other stocks because (1) properties generate high and consistent cash flow; and (2) secondly, they must pay out at least 90 percent of their taxable to retain the REIT status.

With our REIT Portfolio, we are able to generate a ~7.7% dividend yield, with a safe 73% payout ratio. Over time, this will grow through a lucrative combination of dividend per share growth as well as reinvested dividends, creating a snowball effect.

Source: High Yield Landlord Real Money Portfolio

As such, we are not dependent on uncertain stock market appreciation to generate attractive returns. With the S&P 500 (SPY) yielding a mere 1.8%, stock investors are generally much more exposed to the risk of future earnings disappointments and excess volatility if and when the growth targets are not reached.

REITs (Particularly Small Caps) Enjoy Better Margin of Safety

The stock market trades today at close to 22x earnings which are significantly above its historical average, especially when considering that we are in a late cycle economy.

REITs, in comparison, trade today at about 18x FFO and a slight discount to NAV which is closer in-line with its historical norm. It suggests that the market has priced in less optimistic expectations in REITs - providing greater margin of safety in an uncertain environment.

For investors who are willing to dig a bit deeper into the REIT sector, there also exist large differences in valuations of smaller and larger REITs:

Source

Small-cap REITs trade today at just around 12x FFO and discounts to NAV - an opportunistic entry point that allows for greater long term returns and mitigated downside in our opinion.

The Best REITs in a Late Cycle Economy

We recently outlined in a separate article that "Not all REITs are Created Equal" - and especially today as we approach the next downturn, we must be very selective to avoid large potential losses.

In a recession, almost every equity sector loses in value, but there's a huge difference in magnitude, with some sectors getting absolutely crushed while others only have limited volatility throughout the cycle.

For instance, hotel REITs lost 60% in 2008. During the same year, healthcare REITs only dropped by only 12% because their cash flow was significantly more resilient to economic shocks. Taking some chips off the cyclical hotel REITs in 2005, 2006, or 2007 and reinvesting proceeds in more defensive healthcare REITs would have been prudent and greatly reduced the pain ahead, but the fear of "missing out" on the rapid gains of hotel REITs late in the cycle blinded so many investors.

Source: NAREIT, courtesy of Hoya Capital Real Estate

We believe that what will drive our outperformance in the next down cycle is our heavy exposure to REIT investments with the following characteristics:

  • Defensive properties. Preferred sectors include net lease, self-storage, residential, storage, and healthcare. These sectors are so resilient that many of these REITs managed to even hike dividends during the last recession. Examples include Realty Income (O), W.P. Carey (WPC), Public Storage (PSA), National Retail (NNN), and Ventas (VTR).
  • Long remaining lease terms with automatic rent escalations.
  • Conservative balance sheet and/or a focus on deleveraging.

(Note: We are currently sharing the full list of our REIT/MLP investments with HYL members along with a report entitled "Our Favorite Picks for 2019.")

Bottom Line

REITs, as a whole, have historically crushed the returns of literally every major asset class including, stocks, bonds, high yield bonds, utilities, value stocks, growth stocks, etc.

"Crushed" is not an understatement when you look at the below chart:

Now consider this: REITs did so phenomenally well despite being less risky than most other stocks:

  • REITs have more stable cash flow.
  • REITs are less volatile.
  • REITs have higher dividend yield and investors depend less on appreciation.

Today, with slowing global growth and peaking interest rates, we believe that REITs are in a safer position than most other stocks. We expect investors to become more concerned about future growth and start seeing greater value in defensive cash flow and dividends.

That said, you absolutely need to be selective to avoid landmines and sort out the best opportunities from the average.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.