Our High Yield REIT Portfolio: Q2 2019 Update

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Includes: CBL, CIO, CXW, DOC, GMRE, GNL, HTA, IRM, IYR, MAC, RLJ, UMH, UNIT, VICI, VNQ, WPG, WY
by: Dane Bowler
Summary

2CHYP has a dividend yield of 8.14%, which more than doubles the index.

This yield is fully supported by a cash flow yield of over 11%, which makes the FFO payout ratio a healthy 68.4%.

We grow the yield over time through opportunistic trading and reinvestment of dividends.

Most of you are familiar with dividend growth investing. 2CHYP (our high yield portfolio) has similar goals of generating an ever growing stream of cash flows but uses a more active relative value approach. Over time, we intend to both grow the portfolio’s income and outperform the index.

Dividend growth investing has worked well for many people as a low stress and somewhat reliable way to grow cash flows over time. It usually involves parking capital in a company that grows its dividends over time and is passive in the buy-and-hold sense of the word. There are clear strengths to this style of investment, but it may be running into some trouble going forward. The dividend champion stocks that have been the driver of this strategy’s success have become significantly overvalued; now trading at rather low yields and high multiples relative to growth. Thus, there is now risk of significant capital losses from today’s price in addition to lower current dividend returns.

I would like to suggest a more active alternative to dividend growth investing:

Dividend Engine Investing

Rather than parking one’s money in a stock and waiting for that company to slowly raise its dividends over time, we actively trade between securities to increase the cash flow of our portfolio. Market prices are constantly in flux, and by opportunistically selling appreciated securities for discounted peers, we can continuously increase our net yield.

2CHYP commenced trading on 7/1/16 with $100K and now (as of 6/30/19) has annual dividends of $9,690 without any capital added to the account. That is essentially a yield on cost of 9.7%. How does this work?

We are constantly evaluating the relative value of similar securities. Market noise will make one peer more opportunistic at a certain time and the other more opportunistic at another time, and by actively trading between the peers into whatever presents a better value at the time, we can increase our yield beyond what either security would deliver alone.

To illustrate this concept, let us consider 2 peer triple nets each with well supported yields of 8%. Assuming both are at equally opportunistic valuations and have clean dividend coverage, we would, in this example, own both in equal quantities.

As time goes on, some market noise hits. One of the securities stays flat, and the other drops materially to a yield of 8.8%. We would take this opportunity to sell the security that stayed flat and move the capital into the security that dropped. The market gifted us with a 10% dividend increase on the transferred capital. Eventually, the noise corrects itself, and the security trades back up to an 8% yield. At this point, we would transfer half of the capital back over to the other security. We would have the same securities we started with, but thanks to the opportunity granted by the market, we would have more shares of both, and therefore, a higher dividend income than if we just sat in the stocks.

This example represents the ideal. In practice, it does not always work out this cleanly, but it is what we attempt to do, and it is largely the means by which 2CHYP has a 9.7% yield on cost. It is not market timing or technical analysis, but rather a constant diligence of watching the market and buying/selling at opportunistic valuations.

The other key concept behind a high yield portfolio is to have strong cash flows with ample coverage of the dividends. This is why we have built 2CHYP to not only have more than double the yield of the REIT index but also a better level of FFO coverage. Here is how 2CHYP stacks up relative to the REIT index.

Every dollar invested in the REIT index generates less than 5 cents of FFO, while each dollar invested in 2CHYP generates over 11 cents of FFO. This greater cash flow yield pays for the 8.14% dividend as well as organic growth from the remaining 32% of FFO that is reinvested in the REIT’s businesses.

The contrast between the metrics of 2CHYP and the index is extreme and would not be possible in a normal environment. We are not in a normal environment.

An enormous passive share has nearly eliminated price discovery in the market. Pricing is now driven by ETF fund flows which buy and sell without regard to fundamentals. As passive share increased, large caps became substantially overvalued, given that they are the overwhelming recipients of ETF buying. Small-cap value REITs have been left in the dust, with many high-quality names languishing at rock-bottom FFO multiples.

Rising passive share has adversely impacted market pricing for these securities, but it does not hurt their fundamentals or their cash flows. This affords capture of abnormally large amounts of cash flow on our invested dollars, and as of 6/30/19, we allocated as follows to take advantage of the opportunity.

We are not just chasing yield by dumping capital into the most downtrodden sectors. 2CHYP is diversified with exposure to a wide range of economic sectors.

In fact, we are slightly underweight retail relative to the Vanguard REIT ETF (VNQ), which holds 13.1% retail.

I would place 2CHYP’s holdings into 3 main categories (in no particular order):

The dividend backbone - Idiosyncratic risk plays - Asset value plays

Dividend backbone

Triple Net REITs are the closest REIT equities get to bonds as they have contracted cash flows with value adjustments based on credit risk. Gladstone Commercial (NASDAQ:GOOD) is consistently undervalued by the market as its credit risk looks higher on paper than it has been historically demonstrated to be. Other triple net REITs like to boast about their percentage of revenue that comes from investment grade tenants, while GOOD does not concern itself with this metric. Rather than building a statistic to show investors, GOOD is looking at actual credit risk by individually analyzing each tenant as well as that tenant’s need for the property. Getting officially credit rated is too expensive for many smaller players, but that does not mean they are not creditworthy. They simply do not have a document saying they are creditworthy. GOOD has internal expertise in identifying potential tenants that have high credit but are unrated. This affords them higher rent while also maintaining downside protection, which helped maintain their dividend through the entire financial crisis.

Global Net Lease (GNL) takes the opposite approach and has built a portfolio with an impressive concentration of investment grade tenants. When combined with the long weighted average lease duration, GNL’s cash flows are quite secure. The market presently has a tremendous distaste for high payout ratios and punishes those like GNL that are around 100% payout. I would rather see a 90% payout ratio also, but a 100% payout ratio on a 10.6% yield is far better than the 90% payout on a 4% yield where most of the NNN REITs are trading. It doesn’t take high level math to see that GNL is raking in far more cash flow on the investor’s dollar.

VICI Properties (VICI) is not traditionally viewed as a triple net REIT due to the gaming nature of its properties, but its cash flows look very triple net to me. As Caesars (NASDAQ:CZR) merged with Eldorado Resorts (NASDAQ:ERI), antitrust required disposition of some assets, and VICI Properties scooped up $3.2B of assets at a 7.9% cap rate. Along with this acquisition, nearly all of VICI’s existing leases got extended to 15 years with healthy rent escalators. That is some clean triple net cash flow.

The primary risk to VICI is that they are roughly 90% exposed to a single tenant. Thus far, we feel comfortable with that risk for 2 reasons:

  1. Caesars has more than 3X EBITDAR coverage of rent
  2. The rest of 2CHYP has 0 exposure to Caesars, so the risk is somewhat mitigated through diversification.

Our preferred holdings are our means of taking advantage of the mispricing within the capital stack. The market will often trade preferreds in tandem with common stocks. When common stocks drop, the preferreds often drop with them, but fundamentally, this should not be the case. Because of the way the waterfall works, events that impact one area of the capital stack may not impact others and in some instances may even have fundamental impacts in opposite directions for preferred and common shares.

One instance of this is CBL Properties (CBL) cutting its common dividend and suspending it. In both instances, the preferred dropped with the common and now trades at just a fraction of par value. Fundamentally, however, a reduction in payments to common shareholders is great for the preferreds. It retains more capital at the company which goes toward securing the liquidation preference of preferred holders.

CBL is absolutely having trouble, but our calculations suggest it is unlikely that the trouble will be so severe that the preferreds are not made whole.

Farmland Partners Preferred B (NYSE:FPI.PB) is a less extreme version of CBL.PE. FPI.PB is only lightly discounted to par, but its risk is minimal relative to the high coupon and farmland value appreciation participation.

At USDA ascribed land value, the liquidation preference of FPI’s preferred is extremely well covered. Land values would have to fall by a historically significant amount before the preferreds get touched.

FPI is facing some challenges, including weak expected harvest yields due to overly wet weather in the Midwest, recovering but still low commodity prices, and an extended period of low farm incomes which may cause farmers to push back on rent. Each of these problems is temporary in nature, but could still harm near-term earnings and common stock valuation. The preferred is well insulated from anything except extreme scenarios that are virtually non-existent in the history of American farmland.

Global Medical REIT (GMRE) is a medical office REIT without a medical office multiple. Medical office buildings or MOBs are one of the best healthcare property types because they benefit from a secular trend favoring outpatient over inpatient. The market knows MOBs are a strong asset class and trades the MOB REITs (Healthcare Trust (HTA) and Physicians Realty (DOC)) at about a 16X FFO multiple. Due to being relatively newer and smaller, GMRE is trading at a 13X multiple.

GMRE’s management is talented. Their CIO is among the best in the business at selecting quality acquisitions, and the CEO has a reputation of profitably taking his companies full cycle. I also believe GMRE has better properties and operators than Physicians Realty. The multiple gap is not fundamental in nature, and we think it will close over time.

City Office REIT (CIO) is among the cheapest office REITs, yet it has close to the highest growth rate. Its growth comes from a combination of organic same store NOI and high cap rate acquisitions. At 2-4% guided same store NOI, CIO’s healthy growth rate comes from its properties being clustered in high job and population growth submarkets like Phoenix and Tampa. This affords strong leasing spreads and slight occupancy gains.

Iron Mountain (IRM) is the only REIT of its kind, so we cannot compare its multiple to direct peers. Instead, we can look at the 10.5X AFFO multiple relative to its growth and quality. IRM is the global leader in physical data storage, and it is using this position to become a leader in digital data storage. A business that has its sensitive documents already stored in IRM’s vaults is going to choose IRM for its conversion to digital because it is simply less work and fewer eyes looking at their sensitive documents. If IRM has already guarded their documents for years, there is going to be some trust built into the relationship.

Through this data conversion opportunity along with substantial inflows of storage items internationally, IRM has a runway of growth that is far greater than would be suggested by a 10.5X multiple. IRM got cheap on weak 1Q19 margins resulting from oversight in employee overtime. This problem has been dealt with, and the core business remains on track as evidenced by the revenue beat in the same quarter.

Recall that 2CHYP’s engine of dividend growth involves converting capital gains into dividend streams, and to do this, we need some stocks that have high capital gains potential.

Idiosyncratic risk plays

CoreCivic (CXW) has an 8.4% dividend yield, but I do not consider it part of the dividend backbone of the portfolio because the primary goal of this position is to appreciate to its fair value, which I see in the low $30s (about 50% upside). CXW trades deeply below its fair value because of political risk as many 2020 presidential hopefuls are critical of the private prison industry.

Risk often correlates with higher expected returns. Market participants do not like risk and, therefore, require a higher return from stocks that are perceived as riskier. The diversification of 2CHYP affords a sort of arbitrage on CoreCivic in which we get to capture the enhanced return upside of the opportunistic valuation at which CXW trades while mitigating the risk through the idiosyncratic nature of this risk within the 2CHYP portfolio. In the event that certain candidates are elected and crack down on private prisons in the way they proposed, CXW would be the only stock in 2CHYP to get hurt. Thus, our overall portfolio has a reasonably small exposure to the risk.

Uniti Group (UNIT) has a similarly idiosyncratic risk in that the rest of the portfolio has essentially no exposure to either telecom assets or Windstream (OTCPK:WINMQ)). UNIT is presently priced for an outcome ranging between lease rejection and a 50% cut, and when the worst case scenario is priced in, even a mediocre outcome can result in significant price appreciation.

For both CXW and UNIT, the risks are being priced in as near certainties, but the fundamental outlook is far better than that. There have been many previous administrations with disapprobation for the private prison industry, yet the fundamental need for safe places to house detainees has consistently ensured their survival and most of their revenue streams. ICE does not have any facilities of its own and, therefore, needs to contract out.

Recent moves indicate that those who are most familiar with UNIT’s situation are projecting a favorable outcome. PEG Bandwidth, which was the holder of UNIT’s Preferred A just converted their entire position to common shares; a move that only makes sense in a positive outcome. On the debt side, UNIT stakeholders are also calling for upside as UNIT was able to issue very low cost debt with a conversion option involving a strike price in the $12s. We have long believed that Windstream is financially incented to assume the lease or some mutually favorable renegotiated version, and it is nice to have parties with increased information feeling the same way.

Asset Value Plays

These consist of companies whose stocks have been unfairly or excessively beaten up by the market.

UMH Properties (UMH) is a growth company with a competitive advantage in the manufactured housing space. A combination of occupancy growth and rate increases is driving industry-leading same-store NOI, but the growth has not yet shown up in the bottom line for 2 reasons.

  1. The securities portfolio had a couple bad quarters which hurt FFO.
  2. Excessive deleveraging.

Both of these are past events and unlikely to sustainably recur going forward. The securities portfolio, like any other, will go up and down with the whims of the market but, over time, will most likely generate a positive return approximating that of the market. We should not be looking at this on a quarterly basis, but rather as a smoothed run rate.

The deleveraging will stop because the balance sheet is now at extremely low debt. Going forward, UMH has multiple acquisitions lined up along with cheap financing from Fannie Mae, which should cause leverage to stabilize or slightly increase.

With these 2 factors getting out of the way, UMH’s organic growth, which by all accounts looks poised to continue at an impressive rate, will finally show up in the bottom line. When this happens, I believe the market will revalue UMH from a value multiple to a growth multiple. We see significant upside in share price.

Weyerhaeuser (WY) is being priced like lumber as a commodity. Yes, WY does sell lumber, but the value of its assets which are primarily land is quite steady. Commodity prices will affect near-term cash flows but have little bearing on long term intrinsic value. The long run value is related to the productivity of its land and the long run expected prices of lumber, oriented strand board and timber. Each time the market price of WY falls based on the current pricing of commodities, a gap opens up between intrinsic value and market price. Now is one of those times, and we intend to take full advantage.

RLJ Lodging (RLJ) is doing everything right and getting punished for it. They are dramatically shrinking share count through buybacks and upgrading the portfolio through disposition of their weaker assets. These lower growth assets are naturally at higher cap rates, so the dilution of these dispositions is netting out the accretion of the buybacks. Thus, what the market is seeing is flat FFO/share. What is being missed is that the FFO is now of far higher quality. RLJ is now positioned for long-term organic growth, and that should be priced at a multiple significantly higher than 7.9X.

I think when people see a company’s market price fall dramatically, the baseline assumption is that the company is failing or at least struggling. Macerich (MAC) has suffered one of the most precipitous price drops among REITs, falling from over $90 a share to the low $30s.

Something must be failing right?

Well, just about the entirety of the price drop is multiple contraction. MAC has historically been the premium mall REIT, trading at or near the highest multiple in its peer group.

Source: SNL Financial

Over the past 5 years, the average multiple of the REIT index increased slightly from ~20 to ~21 while MAC’s multiple fell from ~20 to less than 10X. Fundamentally, MAC looks as strong as ever. Even in these challenging retail times, MAC’s same store NOI has remained positive, and sales per foot have exceeded $700. MAC now trades at just 58% of NAV and a dividend yield of about 9%. I don’t think it will return to $90 a share anytime soon, but current market pricing is, in my opinion, an obvious bargain.

Washington Prime (WPG) is essentially the ugly stepchild of Macerich. Its properties are less impressive, and its growth has been a bit weaker, but the discount is even more extreme with WPG trading at 3.3X FFO. This is a risky stock, and there are scenarios where the FFO disappears, so this investment is about weighing the scenarios to approximate an expected value.

WPG has issued guidance calling for 2019 being the trough and positive organic growth commencing in 2020. Positive growth cannot sustainably coexist with a 3X multiple. If WPG can come anywhere close to hitting this guidance, there will likely be substantial multiple expansion. It could fail, it could double or it could triple. We cannot calculate the exact probability of each scenario, but I believe the weighted average outcome is better than $3.80 a share.

While I believe WPG’s guidance is optimistic, Louis Conforti (WPG’s CEO) isn’t the type to overpromise and underdeliver. There must be at least some reasonable possibility of hitting those numbers, or I don’t think this guidance would have been issued.

No Style Drift

It has been a challenging 3 years to be a value REIT investor with a small cap tilt.

  • REITs have underperformed the S&P
  • Value has underperformed growth
  • Small caps have underperformed large caps.

These triple headwinds have made price appreciation hard to come by, but we managed to survive the period of our style being out of favor through active trading and our dividend engine.

2CHYP has strong base cash flows from a high dividend yield which is then reinvested in high dividend stocks. We further increase the cash flows through opportunistically trading out of issues that have reached fair value into other stocks that are at deep discounts and higher yields. Over time, the cash flow yield of the portfolio should compound and grow at a healthy pace.

The dividend engine is evergreen. It works through the winter we just experienced, and it continues working when the sun shines. We believe this will cause a slingshot effect when value, REITs, and/or small caps come back into favor. The strong dividend return will still be there, but it will be supplemented with price appreciation.

I don’t know when the momentum will turn around, but fundamentally, it is inevitable. The key is to not fall into the trap of style drift. If we were to morph into growth investors just because that has been working in recent years, we would risk missing the boat with value comes back into favor. We would essentially be on the out of favor side in both directions.

By sticking with our style (value, small cap, high yield REITs), the upside of being in favor, whenever that happens, will cancel out the downside of having been out of favor.

History is on our side

The past 3 years have been unusual as over long stretches of time value outperforms, small cap outperforms and REITs outperform. I don’t believe the fundamental fabric of the economy has changed, rather this is simply a period of odd market pricing. Greater than a decade of expansion can lead to wonky pricing, but mispricing corrects itself over full business cycles.

Performance

Over its 3-year history, 2CHYP has slightly outperformed our stated benchmark, the iShares U.S. Real Estate ETF (IYR). We returned 20.28% compared to 18.16% for the IYR.

REITs as an index came in slightly weaker at 12.93% for the 3-year period.

I don’t know when market pricing will start cooperating, but I do feel confident that this portfolio is well positioned to continue growing its dividend stream.

Important Notes and Disclaimer

The holdings presented were the entire holdings of 2CHYP as of 6/30/19, but may not represent the holdings for other time periods. We do not intend presentation of 2CHYP’s holdings as a recommendation, but rather as a statement of historical fact.

We cannot determine whether the portfolio holdings presented are suitable for any given reader. Readers are encouraged to contact their financial professional to discuss the suitability of any strategies or holdings prior to implementation in their portfolio.

The specific securities identified and described herein do not represent all of the securities purchased or sold for advisory clients of 2nd Market Capital Advisory Corporation (2MCAC). It should not be assumed that investments in the securities identified and described were or will be profitable.

A list of all prior purchases and sales made by the investment advisor representative (Dane Bowler) in the 2CHYP portfolio is available upon request. It should not be assumed that purchases and sales made in the future will be profitable or will equal the performance of the securities in this list.

Benchmark Comparison: 2CHYP portfolio is compared to the iShares REIT ETF (IYR) because it is a common method for investing in a portfolio of REITs and we view it as competitors or alternatives to 2CHYP. IYR has fees that are factored into performance, while 2CHYP does not have a fee aside from trading commissions which are factored into performance. 2CHYP’s dividends are reinvested, while IYR’s dividends are paid but not reinvested.

Strategy and market conditions: 2CHYP uses a bottom up stock selection process which may fare better in certain market conditions than in others. It may perform better when value is in favor or worse when value is out of favor.

Expenses: Returns reflect the deduction of any transaction expenses. There are no costs or management fees charged nor deducted.

Past performance does not guarantee future results. Investing in publicly held securities is speculative and involves risk, including the possible loss of principal. Historical returns should not be used as the primary basis for investment decisions. Although the statements of fact and data in this article have been obtained from sources believed to be reliable, 2MCAC does not guarantee their accuracy, and assumes no liability or responsibility for any omissions/errors.

Calculation Methodology: 3 year return for the period 7/1/16 through 6/30/19, unaudited. Dividends in 2CHYP are reinvested.

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.

Article disclosure:

2nd Market Capital and its affiliated accounts are long CBL-E, CIO, CXW, FPI-B, GMRE, GNL, GOOD, IRM, MAC, RLJ, UMH, UNIT, VICI, WPG, and WY. I am personally long CBL-E, CIO, CXW, FPI, FPI-B, GMRE, GNL, GOOD, IRM, MAC, RLJ, UMH, UNIT, VICI, WPG, and WY. 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.

Disclosure: I am/we are long CBL.PE, FPI, FPI.PB, CIO, CXW, GMRE, GNL, IRM, GOOD, MAC, RLJ, UMH, UNIT, VICI, WPG, WY. 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.