Seeking Alpha

This 7.4%-Yielding Portfolio Will Survive A 2008 Repeat

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Includes: HPT, IIPR, ILPT, IYR, KRG, O, OHI, OPI, RMR, SNH, SPG, VNQ
by: Jussi Askola
Summary

High-quality companies are the key building block of any portfolio built to withstand economic storms.

Maintaining healthy diversification into defensive sectors is essential to reduce risks and portfolio volatility during economic panics.

Avoiding the urge to be greedy and keeping leverage low, especially in riskier assets, are essential to avoid getting wiped out in a market crash.

Buying securities trading at meaningful discounts to intrinsic value provides a margin of safety that will reduce losses in a market downturn.

Maintaining strong dividend coverage is also essential so that stock losses in a downturn are not magnified by steep dividend cuts.

Co-produced with Samuel Smith

With the economic outlook growing increasingly uncertain, we are slowly but steadily taking steps to ensure our real money portfolio is prepared to face the next market downturn. While we are not market timers in the sense that we remain fully invested, we believe that maintaining a disciplined long-term approach and avoiding the urge to be overly aggressive in chasing every high yield, undervalued opportunity that comes along today in order to maintain a high level of liquidity is prudent at this phase of the cycle. In order to bolster our portfolio against a potential economic storm, we are emphasizing diversification, quality, and defensiveness over immediate total returns while still managing to average a high-single-digit yield across our portfolio. We are also keeping a close eye on our overall portfolio leverage and continuing to purchase assets with sizable margins of safety and well-covered dividends.

Quality Is King

When it comes to fortifying a portfolio in preparation for a market storm while simultaneously remaining fully invested, few things can beat quality. In fact a recent study by The Leuthold Group found that quality not only corresponds with long-term outperformance, but also more importantly leads to even greater outperformance during bear markets.

When evaluating real asset securities for our Core Portfolio, we follow the following guidelines when searching for quality:

(1) Aligned Management

Management can make or break an investment, and this is particularly important with REITs given the extensive deal-making, balance sheet management, and leasing, and repurposing/redevelopment operations that go on in the sector. When looking for aligned management, the best indicator is the level of insider ownership. Another - though less important - indicator is if the CEO's name is included in the REIT. Examples of this are Kite Realty Group (KRG) whose CEO is John Kite and Simon Property Group (SPG) whose CEO is David Simon. If a CEO's name is included in the company name, he or she is far more likely to do everything they can to promote and protect that reputation and performance of the company as a big part of their professional legacy.

Source

An area where we tend to exercise extreme caution is with externally managed REITs, as we strongly prefer them to be internally managed for alignment of interest. Exceptions exist, but generally speaking externally managed REITs suffer from greater conflicts of interest, have greater G&A cost, and shareholder returns have been significantly lower over time. The reasons that led to underperformance in the past remain perfectly relevant today, and we do not expect future results to be drastically different. Therefore, by simply skipping all the externally managed REITs, investors can improve their expected returns as compared to index funds that hold exposure to many externally managed REITs.

Even if an externally managed REIT is very cheap, it does not necessarily become worthy of an investment candidate if we cannot rely on the management and its integrity. This has allowed us to avoid numerous serial underperformers such as the RMR (RMR) managed entities: Senior Housing (SNH), Hospitality Properties (HPT), Industrial Logistics Properties (ILPT), and Office Properties (OPI) that cannot be trusted.

That being said, we still do remain open to REITs with external management if the conditions are right. This typically requires that they offer a compelling entry price point, a proven track record of excellence, considerable insider ownership, and have a portfolio of high-quality and well-positioned assets.

(2) Possess a Conservative Balance Sheet

Essentially, these REITs need to have a balance sheet that can weather an economic storm without forcing the company to flirt with bankruptcy or even take on a permanent loss of significant capital. Quantity of leverage - while certainly something to consider - is not so important to us as is the laddering of debt maturities, the structure of the leverage (perpetual (i.e., preferred), long-term, and/or non-recourse are all ideal), and the company's liquidity relative to expected capital requirements.

(3) Possess High Quality and Well Positioned Assets

As landlords, we are most interested in the quality of the portfolio as ultimately what our tenants are paying for is access to our real estate. The better it is, the more likely they are going to be willing to pay and continue to pay for years to come. A well-positioned portfolio of well-located world-class assets will not only thrive in its current marketplace, but has a high degree of weathering economic downturns as one the last places that tenants will want to leave. They will also be much easier to repurpose if necessary given their attractive location.

With a sizable and growing portion of our portfolio possessing these traits, we believe that we are poised to outperform the broader REIT and financial markets in the next downturn.

Diversification: The Only Free Lunch in Investing

When preparing for economic hardship, we swear by the principal of diversification. Our portfolio currently has 19 positions with no single stock taking up more than 7.8% of our total portfolio as of this writing (and that position is arguably our safest investment). That way, if one of our holdings were to suffer from disappointing performance and have to cut its dividend, it does not have a large impact on our overall income. Furthermore, most of our holdings are currently growing their dividends, meaning that a single moderate dividend cut would in fact likely have minimal to no impact on our overall income.

This conviction is not just our overconfident opinion; it is backed up by research. Empirical data suggests that the 100+ position stock portfolios held by many index ETFs is unnecessary. According to studies cited by Morningstar:

"About 90% of the maximum benefit of diversification was derived from portfolios of 12 to 18 stocks."

Not only does our portfolio have near identical safety to a REIT index ETF, but it also has the advantage of allowing us to eliminate the worst investments in the sector and focus on our best ideas, making achieving alpha a much more attainable prospect.

Additionally, our diversification principle keeps us from putting too much capital to work in any single sector. No single sector occupies even 18% of our total portfolio, and our five largest sectors are all fairly defensive (Blue Chip MLPs, Net Lease, Storage, Residential, and Industrial) and combine to make up over 60% of our overall portfolio. We believe that this positions us very well for the next market downturn.

Time to Play Defense

Real estate is one of the safest sectors to invest in from a long-term point of view. This is because, unlike most businesses, landlords benefit from many risk-mitigating factors that allow them to earn much more consistent and predictable income over time. Landlords participate in the profit earned by their tenants through rents that are contractually guaranteed - often for many years to come. Landlords also get paid first. Without paying rent, a business cannot keep operating and therefore rents are senior to even debt payments in most cases. 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 0, but the landlord is in a much safer and stronger position to sustain value. Furthermore, 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.

Source

That being said, we still recognize that it is not risk free and steep losses can still be experienced in the sector, like were seen in 2008-2009. As a result, we have recently been selling some of our riskier REIT investments to lock in gains and then have reinvested the proceeds into either preferred shares or undervalued blue chip REITs in more defensive sectors such as net lease, industrial, and residential. This should set us up to continue achieving strong underlying performance in our portfolio and compound wealth relatively uninterrupted despite the broader economy struggling.

Avoiding The Urge To Be Greedy

As Warren Buffett has wisely stated:

"When leverage works, it magnifies your gains. Your spouse thinks you're clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade - and some relearned in 2008 - any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people."

We religiously take his advice and avoid using leverage in our portfolio. This served us well as recently as this past December. While the markets were selling off, rather than panicking about our rapidly declining portfolio and selling at the bottom in worries about a potential margin call, we actually had cash set aside along with our incoming dividends to reinvest in blue chip REITs trading at remarkable discounts. Since then, these moves have paid off handsomely. While everybody wants a shortcut to build wealth, we remember that it took even Warren Buffett decades to accumulate his impressive investing status. As long-term-minded landlords committed to the time-tested method of gradual wealth accumulation through REIT value and dividend growth investing, we see little to no use for using margin in our portfolios that could erase years of progress in a mere week or two of heavy market volatility.

Margin of Safety Investing

Today - despite the overall frothy market conditions that exist - there remains a massive disparity in REIT valuations with some trading at massive premiums to NAV while others trade at large discounts to NAV. Several blue-chip REITs trade at over 50% premiums including Realty income (O), Omega Healthcare (OHI) and Innovative Industrial (IIPR). This disconnect has in large part been driven by the surge in passive investing as large REIT index funds such as the Vanguard REIT ETF (VNQ), which has over $60 billion in assets under management, buy enormous positions in large cap REITs regardless of how well the current price correlates to underlying performance or net asset value. This has the disrupting effect of creating a price premium in large cap REITs relative to small cap REITs. Today, this has reached a rather extreme point with small cap REITs valued at a ~40% discount to larger peers without regard to actual underlying fundamentals or property values.

According our experience (and academic studies), such lofty valuations in many popular REITs today lead to poor investment results in the long run. Conversely, REITs trading at discounts to NAV have historically produced superior returns as buying real estate for materially less than what it is worth is a strategy that can produce outsized cash flow and appreciation in the long run. As a result, we target primarily REITs that trade at sizable discounts to NAV. We believe that this "value" approach to REIT investing will continue to produce alpha-rich returns because:

  • (1) We enjoy greater margin of safety by buying below intrinsic value.
  • (2) We have superior appreciation potential.
  • (3) While we wait, we enjoy a greater cash flow yield.

Each investment won't perform well by following this approach, but a well-diversified portfolio is expected to outperform indexes in the long run. In fact our portfolio today - despite being overweight defensive sectors and focused on quality and diversification - yields nearly twice what major REIT ETFs do. This is clear in the chart below where we see that VNQ and iShares US Real Estate ETF (IYR) yield just under 4% and 3%, respectively.

Assuming someone needed about $80,000 per year to comfortably fund their desired lifestyle in their golden years and wanted to split the fund evenly between these two ETFs for diversification, they would need to invest about $1.8 million.

In contrast, our diversified real money portfolio currently yields 7.37% with a low payout ratio of only 68.54%.

Source: The Author

This means that a portfolio with our active approach to investing generates 86% more income per year than it would if it was put into the VNQ, without really taking on much more risk at all. This means that to generate the desired $80,000 in annual income, a retiree would only need to invest just a tad over $1 million to retire comfortably.

We believe that by focusing on REITs trading at significant discounts to broader REIT and market index funds, we are putting the odds in our favor to outperform over the long run, including during the next downturn. Furthermore, our low payout ratio means that we should experience fewer dividend cuts and therefore experience more stability in our income stream during the next recession than would other investors chasing high yield or popular REITs without heed to fundamentals or valuations.

Investor Takeaway

Investing is never easy as there is always a huge cloud of uncertainty overhanging the global economy as well as individual sectors. As contrarian investors, we do not shy away from uncertainty or negative sentiment, but rather embrace it. At the same time, we recognize the prudence of guarding carefully against downside risk, particularly at this late stage in the economic cycle.

As we have outlined in this article, by sticking to a few simple principles and exploiting the valuation disconnects in the REIT marketplace caused by the surge of passive investing, we are able to set our real money portfolio up for high current income and total return long-term outperformance while still positioning our portfolio rather defensively.

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.