By the Sure Dividend staff
Real Estate Investment Trusts, also called REITs, are very popular among income investors. There is good reason for this. REITs are arguably the best way for investors to benefit from owning real estate, without having to purchase physical properties.
In addition, REITs are especially attractive for income. With the S&P 500 Index yielding ~2% on average, and further interest rate hikes having been put on hold for the time being, high income is hard to find. Fortunately, many REITs have high yields of 5% or more. You can see our full list of 5%+ yielding dividend stocks here.
In this article we will discuss three high-yield REITs with promising total return potential: Senior Housing Properties Trust (SNH), Brookfield Property Partners/REIT (BPY)/(BPR), and Tanger Factory Outlets (SKT). While not without risks, we believe that these REITs present investors with attractive total return potential by combining a relatively favorable macroeconomic environment, with the advantages that REITs possess and sizable discounts to their underlying net asset values.
Interest rates appear to be peaking for the foreseeable future (though longer term, they will likely eventually go up again at some point) and global economic growth seems to be slowing down. These observations are confirmed by projections from the Federal Reserve and numerous other well-respected economists that economic growth is projected to slow over the next several years, with some even calling for a recession to hit sometime in the next few years.
The warning signs that this could become a reality include data from major U.S. trading partners showing signs of slowing, if not shrinking economic activity. This list includes much of Europe (in particular Italy, which is already in recession) as well as Asian powerhouses Japan and China. Given these countries' significant ties to the U.S. economy, it is only a matter of time before these trends hit American shores. The only reason it likely hasn't yet is due to the still-rippling boost from the 2018 tax cuts as well as the significant roll back of regulations from the Obama era.
The recently escalated trade war with China is also an item of major concern, as ever higher tariffs get slapped on each country's exports to the other's ports. Given the hundreds of billions of dollars that pass between the two countries each year, the impact of this disruption will be more than minor, and could plunge one or both economies into full recessionary mode if left unchecked over a prolonged period of time.
Finally, thanks to over a decade of quantitative easing and artificially low interest rates from the Federal Reserve, household, corporate, and government debt levels have spiked to new record highs. This has created a bubble like economy where growth and profits have been juiced by applying excessive amounts of cheap capital while discouraging savings. As a result of this environment - which has pushed asset valuations ever higher - investors have had to allocate capital to increasingly risky assets in order to maintain their previous levels of profitability. In the process, economic calculation has been disrupted due to market-level capital costs and consumer demand being artificially tampered with by government/central bank planners. The result is a fragile economy and capital market that is highly sensitive to even modest interest rate increases.
Due to these factors, the Federal Reserve will be forced to keep interest rates close to their current levels. However, if/when a global recession hits and/or malinvestment reaches a point that leads to a bursting of the bubble and a meltdown in the United States, the Federal Reserve will likely have to return to quantitative easing and cutting interest rates once again.
Since investors in general will likely become more worried about future growth and see more value in defensive, China trade-independent real asset investments, we expect the current macroeconomic environment to favor real estate and other more defensive high yielding investments. In such an atmosphere, we expect most of the returns to come from income rather than growth, which bodes very well for higher yielding real estate.
Given the tailwinds for real estate in this environment, real estate investment trusts (otherwise known as "REITs") are a particularly advantageous way to invest in the sector. This is because, relative to owning a small concentrated portfolio of individual rental properties, REITs involve considerably less risk.
First, REITs enjoy far superior liquidity since they can be traded in a click of a mouse at a very low (potentially zero depending on the brokerage) transaction cost as opposed to all of the time and expense that goes into selling a physical property.
Second, REITs have far less cash flow risk since REITs are widely diversified with 100s if not 1000s of properties and tenants, many of which are investment grade. In contrast, individual rental properties are often concentrated in much fewer tenants, thereby posing the risk of turning into cash burning liabilities if a vacancy occurs. REITs also enjoy less liability risk since shareholders cannot be sued directly, only the company itself. Rental investors on the other hand can be sued directly by tenants.
REITs are also totally passive investments whereas landlording physical properties requires a significant investment of time and effort. REITs - due to economies of scale - also typically enjoy far lower maintenance and capital/financing costs than investing in a small portfolio of rental properties as a private investor. Finally, and most importantly, REITs often enjoy considerably greater geographic and property diversification than a private investor can achieve on his own, setting the investment up for greater long-term risk-adjusted returns.
Indeed, these qualitative advantages have proven themselves to be decisive over the long term. According to a study by Cambridge Associates, over the past quarter century, REITs have returned more than 11% per year while private equity real estate investments returned just 7% on average, a ~400 basis point annual underperformance.
In fact, REITs have also handily outperformed the broader stock market over the long term. The Vanguard REIT index fund (VNQ) generated up to 4x higher total returns than the S&P 500 from 1997 until 2016:
Given that REITs are in general a superior investment to alternatives in and outside of real estate and that the environment seems particularly favorable right now, the ability to capitalize on stock market volatility to buy them at a discount to their private market value, or NAV, can juice returns even further. Here are three REITs trading at steep discounts to NAV that offer particularly promising total return potential right now.
#3 Senior Housing Properties Trust
SNH is a REIT that was founded in Maryland in 1998. The trust specializes in senior care facilities from housing to skilled nursing to medical offices and labs. Senior Housing owns almost 400 health-care real estate assets around the country. The assets are categorized into medical office buildings, triple net leased senior living communities, managed senior living communities and wellness centers. The first three categories make up 89% of operating income.
Recent Performance: Senior Housing reported Q1 2019 results on May 9, 2019. Q1 normalized FFO came in at 37 cents per share, down significantly from 45 cents per share in the year-ago quarter and missing the consensus estimate by 1 cent. Q1 total revenue of $266.3M also trailed the consensus estimate of $268.2M and was down from $275.8M a year earlier. The dismal results didn't stop there, Q1 same-property cash basis NOI fell 8.6% year-over-year, as a slight increase in same-store NOI in total medical office buildings (up 0.8%) was overwhelmed by the steep declines seen in the senior living communities (down 16%).
The company also began its disposition program where is plans to sell up to $900M of assets in connection with restructuring its business arrangements with Five Star Senior Living. Thus far this year, SNH has sold or has agreed to sell 35 properties for total expected proceeds of $64M.
Bull Case: While its recent results have been poor, everything is a good investment at the right price. In the case of SNH, its valuation has reached a point where it has truly become highly compelling at ~5x FFO which is half of our estimated fair value P/FFO multiple of 10x. As a result, despite recently cutting its dividend to a much more sustainable level, it still yields 7.25%. Even assuming no FFO/share growth over the next five years, multiple expansion back towards our fair value estimate should provide a 15% annualized tailwind to total returns, while the dividend yield will add an additional 7.25%. In all, SNH appears poised to return 22.25% annualized returns over the next half decade from deep value current pricing.
We believe this recovery in the valuation and the sustainability of current FFO/share and the dividend payout are all possible because of the influx of baby boomers reaching their latter years of retirement, when demand for senior care and housing is expected to surge (a demographic phenomenon commonly referred to in the industry as "the silver wave").
As a result, long-term demand for SNH's services will continue to increase for many years. The company is also a player in medical office buildings, which also have long-term increasing demand and have shown positive same-store growth in recent quarters, helping to offset the current negativity in senior housing.
Another reason we believe that the total return potential is not a pipe-dream is that, for a company trading at a ~20% cash flow yield, it has a decent balance sheet (near investment grade at BB+ credit rating). The company has over a quarter billion dollars of liquidity (with a market cap of under $2 billion) and recently unencumbered several properties while also paying off $400 million of senior notes. Their debt-to-adjusted EBITDAR is 6.7x and debt-to-gross assets is 42.3% and plan to use their disposition program to deleverage the balance sheet to below 6.0x by year end. As a result, it should be in solid shape to weather the near term challenges until the tailwind from the "silver wave" enables them to gain back the cash flow they will lose from dispositions, leading to multiple expansion.
An additional benefit of the disposition program is that it will likely be selling properties at valuations that exceed the implied net asset value given by SNH's current share price. As a result, these sales should help unlock value for shareholders.
A final reason SNH shares hold promise for strong returns is due to their geographic diversification across 42 states and the District of Columbia.
This diversification should make them more resilient and stable. Given that their shares are priced so cheaply at the moment, the more stable their cash flows moving forward, the more likely their shares are to deliver outstanding returns.
The Bear Case: While SNH has a fairly strong long-term record of growth (revenue has increased at an average annual rate of 19% during the past decade), it has not translated into per-share FFO growth. One culprit is a rising share count, which provides a long-term headwind to per-unit FFO growth. In addition, rising interest expense continues to eat into profits, as well as poor performance of the senior managed care communities. As a result of low FFO growth rates, a high current payout ratio, and poor performance of its senior living communities (in particular at its largest tenant, Five Star Senior Living), the REIT has not only failed to increase its distribution since 2013, it recently cut its dividend.
This dividend cut came as a result of the necessity to give Five Star Senior Living a huge rent cut from $17.4 million annually to just $11 million annually (a 38% reduction) in order to support its ongoing viability. Furthermore, the structure of the leases have been changed from master to management. This means that SNH now has a share in the profits and losses at the properties while Five Star earns a fee for operating and managing the properties. As a result, their cash flow stability will very likely decline along with greater downside (and upside) potential.
#2 Brookfield Property Partners/REIT
BPY was formed in 2013 as one of BAM's limited partnerships. While this means it issues a K-1 (as a Bermuda-based LP), there are two reasons that Brookfield Property appeals to those that typically reject such investments. First, it does not generate UBTI, making the units suitable for inclusion in a retirement account.
Second, Brookfield recently started offering a REIT alternative, known as Brookfield Property REIT which does not issue a K-1. They will each offer identical distributions/dividends both in terms of quantity and schedule.
BPY not only owns primarily office and retail properties but also invests opportunistically in multifamily, logistics, hospitality, self-storage, and student housing properties.
BPY's office portfolio consists of 288 office properties totaling approximately 138 million square feet in many of the world's premier cities. Combined with the Brookfield brand, this vast global network gives them pricing power alongside consistently strong occupancy and NOI growth relative to other office REITs.
Their high-quality retail portfolio contains world-class properties in the U.S., Europe, Brazil, and Asia. With 100 of the top 500 malls in the U.S., these properties are far from dead and dying and attract some of the best tenants while retaining strong pricing power (high teens leasing spreads over the past year, leading other industry peers).
Furthermore, no single tenant accounts for even 4% of total rent and the average remaining lease term is ~6.5 years, giving them significant diversification and cash flow visibility. Finally, BPY believes it can unlock considerable value by leveraging its business network, operational expertise, superior access to low-cost capital, and development acumen by repositioning and repurposing several of the properties with the long term in view. These qualities give it a competitive advantage over many retail REITs.
Recent Performance: BPY/BPR reported Q1 results on May 6th and Q1 FFO and realized gains per unit came in at 38 cents, flat year-over-year. The company saw strong gains from realizations in its LP Investment strategy, increased investment in core retail vs. the year-ago period, and continued same-property growth in its core office operations. However, the results were flat year-over-year due to higher interest rates, a strong U.S. dollar, and a higher unit count (due to the GGP acquisition). Core office operations generated company FFO of $140M in Q1 vs. $153M in the year-ago period (the decline was due to dispositions), core retail operations generated company FFO of $184M in Q1 vs. $116M in the year-ago period (due to same-store growth plus the GGP acquisition), and LP Investments company FFO of $146M increased from $96M a year earlier (due to increased investments and gain realizations).
Bull Case: One of the biggest competitive advantages that BPY enjoys is that BAM owns the majority of BPY's units. As a result, it provides BPY with exclusive access to a huge deal flow through its enormous global network. Additionally, BPY benefits from BAM's strong management and institutional expertise obtained over decades of managing and owning real estate.
By acquiring quality assets at what it believes to be attractive valuations and then adding value through its operational and development expertise, BPY aims to generate long-term returns of 12-15%. Management also enhances returns by routinely selling assets at rich valuations and recycling the capital into higher yielding opportunities in order to repeat its virtuous cycle of value-add operations and dispositions.
Another way in which management expects to drive superior returns over the long term is through its geographic and asset class diversification, giving BPY significant opportunities to continuously deploy capital into attractive markets. It also tends to level overall operating results similar to how a diversified stock portfolio experiences less volatility over time. Furthermore, management leverages its Brookfield connections in order to give it informational and bargaining advantages, enabling it to get superior values on its acquisitions and dispositions.
Another major argument for longs is the fact that BPY's distribution is very attractive. With a distribution yield of ~6.7% backed by 5 straight years of growth, it packs a powerful punch as a dividend growth stock. With another five years of growth, it will become a member of the Dividend Achievers, a select group of stocks with 10+ years of consecutive dividend increases. You can see the full list of Dividend Achievers here.
Given our positive growth outlook for the company, BPY will very likely get there. The company has a target of achieving a 5-8% long-term distribution growth rate, but we believe it will likely come in around 5% per year over the next half-decade since the payout ratio is currently quite high (~85%) and the company is planning to allocate capital towards deleveraging and repurchasing units. We expect the annual FFO/unit growth rate to come in at around 6% per year over that time period, gradually driving down the payout ratio.
While BPY's debt to EBITDA ratio is well over 10x (making it one of the most leveraged real estate investments available in public markets), the structure of that leverage is conservative enough for it to maintain a solid BBB credit rating. 95% of the debt is in the form of non-recourse and self-amortizing mortgages. Additionally, the debt to asset ratio is only a little over 50%, which is pretty average for a REIT. This means that the reason the leverage ratio is so high is due to the low cap rate nature of the properties rather than the fact that the company has a high amount of debt relative to its real estate holdings. The reason that the cap rates are so low is because the properties are of such high quality. As a result, they enjoy strong occupancy and growth rates, further reducing their debt risk profile as they are more likely to weather a recession and, therefore, be better able to service their debt payments.
Perhaps the strongest argument in favor of an investment in BPY is that it appears undervalued based on numerous metrics. First, BPY's current NAV (IFRS accounting) per unit valuation is ~$29 (recently, validated by billions of dollars of dispositions in 2018 and Q1 2019 at prices above IFRS valuations), meaning that unit-holders have the opportunity to purchase equity in its high-quality and well-diversified portfolio at a steep discount. Management has recently reaffirmed its conviction in its steep discount by repurchasing hundreds of millions of dollars' worth of units.
Additionally, using the dividend growth rate model and our estimate of 6% annualized FFO/unit growth over the next half-decade in combination with its 6.7% yield, we project 12.7% total returns. Adding on top of that our expectation that commitment to unit buybacks from management will yield multiple expansion to 16.4x FFO from the current 12.7x FFO, adding nearly 600 basis points to projected annualized total returns. This results in a market-beating 18.7% annualized total return projected over the next five years. Therefore, our view that BPY is materially undervalued seems to have a significant margin of safety.
Bear Case: One of the factors tempering demand for units is the recent GGP acquisition. Due to the market's general wariness of U.S. retail real estate, many investors prefer to steer clear of BPY units. However, we believe that with the deal in the rear view mirror and the dust settling, investors will begin to overcome their initial reservations as they see the tremendous value proposition in these units.
The most significant risks in our mind, however, stems from BPY's extremely high leverage as well as its exposure to international currency and geopolitical risks. However, as previously mentioned when we discussed the balance sheet, there are several caveats that keep us highly optimistic about the safety of this investment. As management executes on its deleveraging plan, we expect shares to be increasingly viewed favorably by investors.
Finally, the geopolitical/macroeconomic risk that comes with its global portfolio is mitigated by the fact that most of the economies in which Brookfield operates continue to be strong/strengthening, liquidity remains plentiful, interest rates remain low and the flattening yield curve portends low upside for further rate increases, leasing contracts typically have inflation increases built in to them, only 26% of assets are generating rent in foreign currencies, and BPY employs currency hedges to further reduce this exposure.
#1 Tanger Factory Outlets
SKT is one of the largest owners and operators of outlet centers in the United States and Canada. SKT operates and owns, or has a stake in, a portfolio of 40 upscale outlet shopping centers. SKT owns properties across 20 states and in Canada, totaling 14.4 million square feet. SKT leases to over 2,900 stores operated by over 500 different brand name companies. More than 189 million shoppers frequent Tanger Outlet Centers every year. SKT is headquartered in Greensboro, North Carolina. Tanger Outlet Centers are known for their tenant mix comprised of leading designer and brand-name manufacturers.
Recent Performance: SKT released first quarter results on May 6th, 2019 and announced funds from operations (FFO) of $0.57 per share, compared to $0.60 per share in the same period of last year. EPS for Q1 was $0.66 per share, compared to $0.24 per share last year, due to a gain on the sale of four outlet centers which added $0.44 per share. Funds available for distribution (FAD) were $0.54 per share, covering the dividend securely with a payout ratio of 65%. Consolidated portfolio occupancy rate were down by 0.5% from last year to 95.4%. Portfolio NOI decreased 0.8% for the quarter, but same center NOI was down slightly less by 0.5%. SKT completed the sale of four non-core outlet centers for $130.5 million. These properties represented 6.8% of the consolidated portfolio's square footage and 5.1% of its forecasted Portfolio NOI. SKT sold these properties as they were declining assets and did not expect them to achieve the portfolio's long-term growth. The cash was used to repay outstanding balances on the line of credit and management is considering increasing share repurchases with some of the freed line availability
Bull Case: As with the previous two examples, the valuation is quite compelling here. SKT offers a dividend yield of 7.7% and we estimate that between 4% average annual FFO/share growth and multiple expansion back closer to recent historical averages, shares should appreciate on average 11.5% per year over the next half decade. All told, shares could return 19% per year during that time span.
The confidence in the bounce back in share prices is based on the fact that the current occupancy and pricing power struggles at SKT is only temporary. The company will bounce back because of its long track record of success that has made it a Dividend Aristocrat (over 25 years of dividend growth; see our complete list and guide to the Dividend Aristocrats here), the strength of its outlet center business model, its fortress balance sheet, and deep discount to NAV.
As the only pure-play outlet center REIT in the world, SKT has benefited from the strong historical performance of this type of property. This business model cuts out the middleman and allows manufacturers to directly distribute to consumers. Therefore, Tanger has zero exposure to struggling department store operators and instead deals directly with strong and growing brands like Nike (NKE) and Gap (GPS) while also mixing in dining and entertainment to keep its properties fresh and attractive.
The company's balance sheet boasts minimal secured debt, strong interest coverage, easily manageable maturities, fixed rate debt and a solid investment grade credit rating (BBB, stable).
These qualities give it a low cost of capital and plenty of liquidity with which to re-invest in its properties to reboot its business performance. As a result, when combined with its historical recession resilience and low tenant cost relative to competing retail models, SKT will be able to survive and eventually thrive while other bricks-and-mortar retailers die off as its outlet centers reinvent themselves into combined dining and entertainment centers alongside valued parts of the emerging omnichannel retail model.
Shares also trade at a huge discount to their historical averages, trading at just 8x FFO and a ~25% discount to NAV. As already mentioned, the current dividend yield is also very attractive and well covered by FFO and supported by a strong balance sheet. Therefore, an investment in SKT today has a huge margin of safety.
Bear Case: The primary thesis of bears is that due to the rapid changes in the retail industry, the outlet center model is going obsolete, or at least suffering from a significant role reduction. As a result, occupancy rates, pricing power, and most of all, growth will decline in the years to come in search of a new (and much lower) equilibrium.
This is evidenced by the facts that few new development opportunities remain today, tenant occupancy costs are rising, rental spreads are turning negative, and same-store NOI is trending negative even as e-commerce, some other bricks-and-mortar retail properties, and the overall economy are all booming.
Furthermore, the outlet model's role as the method of choice by which national brands moved surplus or lower quality inventory is being displaced by e-tailers and other discount retailers like TJ Maxx (TJX) and Ross (ROST).
Another factor that will hurt SKT's ability to reinvent its properties is the fairly poorly located real estate it owns. Outlets are typically built in more rural areas where land is cheap and competition with other developers is lower. As a result, it may be hard to attractive alternative tenants and customers to the tenants outside of traditional outlet shoppers.
Finally, if you look out over the next several years, you will see that a large percentage of their leases are expiring. This could not come at a worse time given that a recession might be looming on the horizon and the REIT's pricing power is already at its worst point in a long time (if not ever).
Further compounding their problems is the fact that their largest tenant (Ascena Retail (ASNA)) - comprising 7% of their rent - continues to head downhill towards a likely bankruptcy.
The bear case is very strong at SNH as the company has a large debt burden and a shaky business model to dig itself out of. That being said, liquidity remains solid and if they can execute on their disposition program without selling assets at too steep of a discount, they should be able to stay in position to capitalize on upside from the silver wave over the next half decade.
While the agreement with Five Star equates to giving them a huge rent cut in the short term, it could lead to strong additional gains if/when the demographics shift to create a more favorable supply-demand dynamic for their properties. With 15 year plus leases on the Five Star properties, there is plenty of time for the demographic shift to play out in SNH's favor. Given the current share price and the more secure dividend, SNH should still be able to generate strong five-year returns for patient investors.
BPY owns a well-diversified portfolio of world-class properties, with the financial, operational, and network advantages that come from being associated with the large and growing Brookfield empire, giving it plenty of options to continue growing and improving its portfolio. Despite these competitive advantages, units remain cheap due to competing investment alternatives and concerns about over-exposure to U.S. retail real estate and over-leveraging as interest rates rise.
However, given the high quality of the properties and the low-risk structuring of much of its leverage, BPY remains a fairly safe investment with very strong total return potential. Finally, its 6.7% distribution combined with its mid-to-high single digit annual growth potential makes it one of the most attractive high yield and income growth combinations available today.
SKT is also not without risks as it is stuck in the crossfire between competition from traditional malls reinventing themselves and rapidly growing e-commerce. While it has a strong track record and plenty of liquidity with which to reinvest in its business, the long-term viability of outlets remains uncertain. That being said, its valuation presents an enormous margin of safety and the dividend alone (which appears quite safe at the moment and should continue to grow over the next several years) can provide solid total returns while waiting for the company to turn around its business performance.
REITs as a whole should provide strong relative performance in the emerging macroeconomic environment and these three add the bonus component of trading at deep discounts to net asset value with bull cases that offer the potential for high-teens annual total returns over the next half decade. That being said, none of them are cheap without reason and investors should carefully weigh the risks of each before investing.
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.