Why REITs Outperform Stocks, And 3 Strong Buys In May 2019

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Includes: AMZN, GOOG, IRM, JCAP, NFLX, RESI, SPY, VNQ
by: Jussi Askola
Summary

It is well-known that over long-time periods, REITs have consistently achieved higher returns than stocks and bonds.

We think that the factors that led to this outperformance in the past; remain perfectly relevant today.

Real estate is a high ROI asset class; REITs invest in them within a tax-advantaged structure; and pay out the majority of their cash flow in dividends.

Today, after a 3-year long streak of underperformance, REITs are ready to get back to market outperformance.

We share three of our Strong Buy-rated REITs in May 2019.

Currently more than 80 million Americans are invested in REITs directly or through REIT mutual funds or exchange-traded funds (ETFs). This is not surprising when you learn that the easiest way to outperform markets in the past 30 years, would have been to overweight REITs in your portfolio.

REITs have consistently generated greater total returns and payed higher dividends, all while being less risky:

REITs outperform stocks and bonds (Source. REITs: dark blue line; S&P500: grey line.)

Counting out the latest 3-year period of underperformance, the return differential is even more important:

SP500 underperforms REITs

(source)

From 1997 to 2016, REITs (VNQ) generated up to 4x higher total returns than the S&P 500 (SPY).

Yet, still to this day, many remain on the sidelines because they believe that this outperformance was the direct result of declining interest rates. Now with interest rates (possibly) back on the rise, they are very skeptical of future performance. In reality:

  • REITs have outperformed during times of rising and declining interest rates.
  • REITs may benefit from rising interest rates (leads to higher rents, lower vacancy, and lesser competition from new constructions.)

Therefore, we strongly believe that the trajectory of interest rates is not the main driver of the past outperformance. The market seems to forget that every investment benefit from lower interest rates and that REITs are not the exception. Moreover, REITs are total return investments; and not bond-like instruments as many seem to believe. Today, this argument is especially weak because REIT balance sheets are the strongest they have ever been; and cash flow growth is positive.

We identify 3 more-probable reasons why REITs keep on outperforming:

  1. Real estate is a superior investment asset class.
  2. REITs combine the power of real estate with tax benefits.
  3. REITs are forced to pay high and consistent dividends. This reduces conflicts of interest, and increases discipline in capital allocation.

Each factor remains perfectly relevant today and results in mechanically repeatable outperformance. Therefore, as long as the valuation of REITs remains favorable, we are confident that REITs are set to continue outperforming stocks in the long run.

Reason 1 – Real Estate is a Very Powerful Asset Class

We strongly believe that real estate is the very best asset class to generate high total returns over long time periods. It is not just our opinion; it is also backed by factual evidence.

Even accounting for the sharpest real estate crash of mankind (2008), real estate beat stocks with lower risk in the past decades:

REITs best risk-to-reward

This is because the simple math behind a property investment is very powerful:

  • Buy at a 6-7% cap rate
  • Finance half of the purchase with a 3-4% mortgage
  • Appreciates at 2-3% per year (along with income growth)

And you get close to 12-15% annual total returns. It is this simple. The assumptions are nothing unrealistic and this is done every day by experienced property investors. The beauty here is that even with these high returns, the risks are not any higher than that of traditional stock investments. Opposite of that, we argue that such property investments are much more conservative because:

  1. Landlords participate in the profit earned by their tenants through rents that are contractually guaranteed – often for many years to come.
  2. 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.
  3. In the worst case where a tenant goes bankrupt, landlords can release the same property to another tenant. The value of the previous tenant’s business may go to 0, but the landlord is in a much safer and stronger position to sustain value.
  4. As a scarce supply and essential part of our infrastructure, real estate provides superior inflation protection – an important risk that should not be overlooked in today’s market environment.

The result is an exceptionally strong risk-to-reward outcome for real estate investors; stronger than that of stocks in our opinion.

Reason 2 – REITs Combine The Power of Real Estate With Tax Benefits

Unlike regular corporations (stocks) which pay corporate taxes on their net income; REITs are tax-advantaged vehicles and pass on these large tax savings in the form of higher returns to their investors.

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 saving massive taxes.

Reason 3 – Forced Dividend Payouts Increase Returns

Finally, REITs must pay out 90% of their taxable income in the form of dividends to shareholders. This often-overlooked rule creates alpha by:

  1. Removing conflicts of interest. It transfers the control of the cash flow from the managers to the shareholders.
  2. Improving the discipline in capital allocation. Since managers do not have a lot of cash flow to play with; they are less likely to waste it on some low ROI projects. Rather, they will often have to access the public markets to raise new equity under the scrutiny of professional analysts.

Moreover, as many research studies have found: dividends make up a very large portion of total returns. Some say it contributes 50% to total returns; others find that it results in up to 90% of total returns in the long run.

The common conclusion is that dividends are a very important component; and that large dividend payers are likely to outperform non-dividend payers in the long run.

dividend payers outperform in the long run

(source)

REITs pay much greater dividends on average; with an average yield of ~4% - roughly the double of the S&P500 (SPY). Moreover, the average yield of REITs can be easily boosted by being selective and focusing more on the undervalued small cap segment.

As an example, our REIT Portfolio has an 7.5% dividend yield, despite a low payout ratio of just 69%, and regular dividend hikes. The higher cash return increases the safety of total returns. We are legally entitled to most of the cash flow, even during occasional bear markets; and we are less dependent on stock market appreciation during bull markets.

What About the Next 10 Years?

Every asset class is subject to changing market sentiment in the short run, and REITs have been out of favor in the recent years due to irrational fears over the rise of interest rates.

As a result, REITs underperformed in past 3 years:

REITs suffer from pessimistic sentiment

After the latest underperformance, REITs have significantly less optimism and growth priced into their share prices - providing greater margin of safety. The same cannot be said about the most large-cap stocks such as Amazon (AMZN), Alphabet (GOOG), or Netflix NFLX) which rely on strong growth to continue generating attractive returns from here.

We are heavily investing in REITs because we believe that they are set for a return to outperformance in the coming years.

  1. Peaking Interest Rates: REITs have suffered from great market pessimism in the past three years due to fears of rising interest rates. Now that these fears are slowly disappearing, the headline risk is removed, and investors are returning to REITs.
  2. Slowing Global Growth: Moreover, now that growth is slowing down in a late cycle economy, investors are becoming increasingly interested in more defensive stocks with consistent income such as REITs.

As a result of these two themes, we expect REITs to go from:

avoid at all cost due to rising interest rates

to:

buy for defensive income in a low growth environment

Since the beginning of the year, REITs have already recovered by over 17%, and we believe that there is more to come:

REITs surge to the upside in 2019

Three "Strong Buy" REITs in May 2019

While we are bullish on REITs, it is important to recognize that not all REIT are created equal, and especially today after the recovery, investors must be selective to achieve strong results.

While the passive indexes may still earn a “hold” rating; we are able to find several Strong Buys in less crowded, yet more lucrative specialty REIT sectors.

Heading into summer of 2019, we are buying shares of the three REITs presented below:

Company

HYL Rating

Risk Level

Allocation Level

Iron Mountain

STRONG BUY

Avg

Avg

Iron Mountain (IRM) is a "growth-at-ridiculously-low-price" REIT with a solid ~8% dividend yield that is expected to grow at ~4% per year. The company is operating a defensive storage business; but after missing on its first quarter results, the shares sold off heavily. We believe that this is one of the best opportunities right now because the underlying business model is doing well and the full-year guidance was maintained. From the dividends and growth alone, we are set for double digit returns. Add to that some FFO multiple expansion and the returns could be spectacular for this risk profile.

Company

HYL Rating

Risk Level

Allocation Level

Jernigan Capital

STRONG BUY

High

Large

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 (in a good way!) from equity REITs, but also from mortgage REITs in that it loans money, receives equity and often provides additional services to borrowers. The results have been phenomenal thus far with very strong returns on invested capital, and the pipeline remains large. Sold at just about 7x FFO, we believe that the company is mispriced by ~40%. While we wait, we earn a well-covered 6.6% dividend yield.

Company

Rating

Risk Level

Allocation Level

Front Yard Residential

HYL STRONG BUY

Avg

Large

Front Yard Residential (RESI) is our deep value pick among single family rental REITs. The company own a well-diversified portfolio of affordable housing rentals and trades at just around half of its NAV. It pays an attractive ~6% dividend yield and we expect double digit annual returns as the company closes down its excessive discount to NAV.

Note: These opportunities and 33 others are outlined for HYL members in "Our Favorite Picks For 2019."

Closing Notes

These three REITs have four things in common:

  • They trade at discounts to their estimated NAV and/or closest peers.
  • They pay high dividends that are expected to grow in the long run.
  • They have ample near-term upside potential
  • There exists clear catalysts for value realization.

Our Portfolio at High Yield Landlord is made of investments like these three. We aim to buy Real Estate at a discount to fair value to fund our target 8% average yield. It's just common sense that buying real estate for materially less than what it's worth is a strategy for superior long term results.

By investing in passive indexes, we believe that REIT investors are set to outperform Stocks.

However, by being selective, we believe that returns can be improved even further. The best REIT investors have achieved up to 22% annual returns over the past decades.

Source

Disclosure: I am/we are long IRM; JCAP; RESI. 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.