Big Opportunity In Small Cap Value REITs

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About: IQ U.S. Real Estate Small Cap ETF (ROOF), Includes: VNQ
by: Dane Bowler
Summary

Small cap REITs are trading at an unusual discount to large cap REITs.

In the broader market, small caps trade at a premium, making this opportunity unique to REITs.

Given the valuation rift, small cap value REITs are generating outsized dividends, fully supported by their greater cashflows.

A massive opportunity has surfaced

As active investors we are continuously searching for pockets of mispricing and at any given time there are usually a few to exploit. Often it comes in the form of one-off opportunities; a stock that dropped a bit too far on a minor news item, or a new source of fundamental growth that has been overlooked by the market. Today, however, there is a major opportunity that is broad in scope and rich with mispricing: Small cap value REITs.

A great valuation rift has opened up between small cap REITs and their large cap peers and I intend to demonstrate this idea through a series of charted data points. For the below analytics we used a data set inclusive of all 169 REITs that have S&P Capital IQ consensus 2019 FFO estimates.

Author generated chart using data from SNL Financial

For clarity, this chart is read with the highest point indicating that there are 13 REITs trading at 20X 2019 FFO. Kurtosis charts get a little wonky at the tails because the sample size is too small to smooth the tails, but the above chart approximates a normal bell curve.

I believe the great value rift has gone un-noticed because on the surface REITs appear to be trading within a normal range. The median REIT is trading at just over 15X 2019 FFO and the rest are normally distributed about the median. Looking at REITs as a whole, it is rather unexciting. However, when the dataset is broken down and analyzed from different angles, the value gap becomes clear.

In the below chart, we took the same data but split it into the smaller 50% of REITs in blue and the larger 50% of REITs in orange.

Author generated chart using data from SNL Financial

Both small caps and large caps approximate bell curves, but the large caps are clearly shifted to the right (higher multiple) as compared to the small caps. In fact, the rightward shift of the large caps is 4.7 turns.

The average FFO multiple for the smaller half of REITs is 13.6X The average FFO multiple for the larger half of REITs is 18.3X.

That is a massive difference in valuation by size. Shown below are all 169 REITs with consensus estimates. The size of bubble represents the average market cap of REITs trading at each FFO multiple.

Author generated chart using data from SNL Financial

The correlation is undeniable. The bigger the REIT, the more expensively it trades.

Unique to REITs

A valuation gap of this size based on market cap is exceedingly rare and seems to only exist in the REIT sector. In fact, if one looks at the broader market, small caps trade at higher multiples than large caps. So why do REITs have it backward?

3 progenitors of mispricing

  1. ETF boom
  2. Value is out of favor
  3. Trade war sent non-REIT investors into large cap REITs

The first 2 are fairly straight forward so I wont spent too much time on them.

Large cap REITs have been outperforming since ETF popularity took off. Major REIT ETFs like the Vanugard Real Estate ETF (VNQ) do not hold small caps in any meaningful quantity and exclude some small caps entirely. Thus, as these indices began to dominate the trading flow, large caps naturally rose above small cap peers.

As for value being out of favor, a simple 5 year chart of the Russell growth versus the Russell value indices makes it quite clear that value has been out of favor for a while.

Source: Google Finance

With the market favoring momentum over cashflows, the mispricing that was started by ETFs was exacerbated by momentum investors. Recessions tend to bring cashflows and valuation back into focus, but as we are now over 10 years into an economic expansion, value has not had its chance to catch back up.

I would argue that these 2 factors (ETF flows into large caps and value out of favor) were largely responsible for the creation of the valuation rift between small cap and large cap REITs and the continuous flows into ETFs have slowly widened the gap over the past few years. Recently, however, the divergence has kicked into high gear. Over the past year, large cap REITs returned about 15% while REITs under $2B in market cap are in the red.

Source: SNL Financial

The reason why has to do with the specificity of REITs as a different asset class than the rest of the market. REITs use FFO and NAV instead of Earnings and book value. These are tricky concepts and can give pause to even experienced broader market investors. Thus, when assets flow from the broader market into REITs, the influx of non-REIT money goes almost exclusively into the large and mega cap REITs. When investing in uncharted territory there is a tendency to go with the crowd which gives large caps a perceived imprimatur of safety.

The big influx of non-REIT money

REITs are correctly regarded as a safe haven from trade war escalations. With largely domestic revenues, tariffs and other fallout from the trade war are unlikely to have a major impact on REIT bottom lines. The market understands this and has poured money into REITs. Quite simply, non-REIT investors are going to put their money to work in the majors like Ventas or American Tower, rather than some micro-cap that nobody has heard of.

The Opportunity

Each of the causes of the relative cheapness of small caps is non-fundamental in nature. In other words, the pricing distortion represents mispricing rather than a reflection of expectations. I want to make clear how big of a difference the 13.6X multiple of the smaller half of REITs is compared to the 18.3X of the bigger REITs or the nearly 20X of the REIT index.

Every $100 invested in the smaller half of REITs generates $7.35 compared to $5.46 for bigger REITs or $5.00 for the index (which overwhelming represents the biggest REITs). Every year the smaller REITs are held, you are coming out ahead in cashflows and dividends by a substantial margin. One can approximate the basket of smaller REITs through a small cap REIT ETF like the IQ U.S. Real Estate Small Cap ETF (ROOF) and I suspect this will outperform the REIT index as represented by the Vanguard Real Estate ETF (VNQ).

There is, however, a much better way to capitalize on the mispricing using individual stock selection. It is entirely possible to build a diversified portfolio of small cap REITs yielding over 8% with fully covered dividends. A wide range of high quality REITs with growing FFO are now trading at sub 10X multiples. This is an unprecedented opportunity and we intend to take full advantage. It may take some time to play out in terms of market prices, but for those patient enough to wait it out the return potential is substantial. Prices will eventually normalize resulting in substantial multiple expansion for small cap REITs which will supplement the base returns from dividends.

Disclosure: This article is provided for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer. Information contained in this article is impersonal and not tailored to the investment needs of any particular person. It does not constitute a recommendation that any particular security or strategy is suitable for a specific person. Investing in publicly held securities is speculative and involves risk, including the possible loss of principal. The reader must determine whether any investment is suitable and accepts responsibility for their investment decisions. Dane Bowler is an investment advisor representative of 2MCAC, a Wisconsin registered investment advisor. Commentary may contain forward looking statements which are by definition uncertain. Actual results may differ materially from our forecasts or estimations, and 2MCAC and its affiliates cannot be held liable for the use of and reliance upon the opinions, estimates, forecasts and findings in this article. Positive comments made by others should not be construed as an endorsement of the writer’s abilities as an investment advisor representative.

Conflicts of Interest. We routinely own and trade the same securities purchased or sold for advisory clients of 2MCAC. This circumstance is communicated to clients on an ongoing basis. As fiduciaries, we prioritize our clients’ interests above those of our corporate and personal accounts to avoid conflict and adverse selection in trading these commonly held interests.

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.