Seeking Alpha

5 Diversified REITs: Which To Buy Which To Avoid

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Includes: BPR, EPR, ESRT, STOR, WPC
by: Thomas Hughes
Summary

The real estate sector is one of my top three target sectors this quarter.

Real estate-related stocks are OK, but don't pack the dividend punch of a good REIT.

I found attractive returns and outlook among the Healthcare REITs, now it's time to look at the diversified REITs.

There's less to choose from but good values are still to be had.

The real estate sector is one of my three target sectors for dividend growth investors this quarter. The reason is simple, real estate, healthcare, and utilities have the best outlook for stable earnings growth through the end of next year. Other sectors may have a better outlook for 2020 EPS, but it's marred by negative growth this quarter and next. While the broad market struggles with earnings growth next quarter, the real estate sector is expecting EPS growth to accelerate.

In my quest to find the best investments within these sectors, I have looked at real estate-related companies and healthcare REITs. The real estate-related companies are OK, there is a positive outlook for growth among the group, but the dividends are pale compared to what you can find with a REIT. I found some attractive yields among the healthcare REITs and even so evidence dividend increases may be forthcoming later this year or next.

For this article, I am turning my attention to diversified REITs. Diversified REITs have some attraction because they offer a "diversified" approach to real estate investing. That said, diversified doesn't mean much when it comes to some of these companies so beware.

What this group has going for it include low valuation relative to S&P 500 stocks, a higher yield than the average S&P 500 stock, and economic trends. In terms of valuation, the S&P 500 is trading about 17X forward earnings while most diversified REITs are trading well below that level. Point of note, my valuation is based on FFO for the REITs, funds from operations, because the P/E ratios are often meaningless.

Empire State Realty Trust (ESRT)

The Empire State Realty Trust is a diversified REIT specializing in the greater NY metropolitan area. The company owns and operates 14 office properties and 700,000 sq ft of retail space, primarily in Manhattan, including the Empire State Building. While most of the portfolio is focused on NY/Manhattan, there are three properties in Connecticut and two in Westchester County, NY.

Empire ranks low on my list due to yield, past dividend growth, value and ROE. The REIT pays the lowest of all five on my list and well below average for an investment vehicle of this type. In that light, the forward Price/FFO ratio is unwarranted; at 15.1, it is among the highest valued REITs in the group. Likewise, the ROE is the lowest in the group which suggests this isn't the best to invest in just now.

In Empire State Realty Trust's favor, the payout ratio is the lowest in the group which makes its dividend the safest and future increase the most likely. At 43.75%, it is about half what you might expect to find, very low. FFO is expected to drop YOY in the next release but only by a penny. Looking beyond that, analysts' estimates have 2019 and 2020 FFO both increasing YOY.

Future revenue growth is being driven by demand. Demand in NY allowed the company to raise its average leasing price by 4% from 2018 levels with little to no pushback from the market.

Q1 2019 Conference Call:

We continue to see demand for our product, location and price points and feel very confident in our offerings. We have raised our weighted average asking rents in our Manhattan office buildings by over 4% on a year-over-year basis, following increases in our asking rents throughout 2018.

We have a healthy pipeline of leases and negotiation across the portfolio for both full floors and prebuilts.

The company has a fortress balance sheet. There is very little debt, total liabilities are little more than 50% of assets, and there is ample cash on hand. Accounts receivable is also substantial, about equal to cash on hand. If not for the low dividend, I'd jump on this one; there is at least some hope of a future increase but not enough for me.

STORE Capital Corporation (STOR)

STORE Capital Corporation (single-tenant operational real estate) is a diversified REIT specializing in real estate intensive business locations. While it does include traditional retail such as Cabella's brick & mortar locations and fast food, STORE's investments span the range of businesses that require large locations and/or prime exposure to commercial traffic.

Like Empire State Realty Trust, this one ranks low on my list because of the yield, valuation, and return on equity. The yield is better than ESRT but still below average for a REIT at 3.91%. The valuation is high at 16.68 next year's FFO consensus, but that may be deserved. The company is aggressively growing its locations and is a dividend grower.

The latest count had the number of locations at just over 2,550. The company invested $400 million in the first quarter alone on new properties and expects to continue that trend in the future. Even better, STORE is paying for its growth with retained cash flow more so than debt.

Source: 1Q Investor Presentation

From The 1Q Conference Call:

We began 2019 with a very active quarter on the investment front with investment activity of nearly $400 million while adhering to the granularity and diversity we are known for. Mary will run you through the numbers in more detail with you but we’re happy with our ongoing success of penetrating the large markets that we address, while maintaining our focus on meeting the needs of our existing customers.

With the dividend payout ratio for the first quarter below 70% of adjusted funds from operations, a meaningful portion of our investment activity is being funded through retained cash flow. We pair that retained cash flow with our historic focus on maintaining annual tenant same-store rent contractual growth of nearly 2% to drive the majority of our expected AFFO growth per share.

While STORE does not have the best yield or lowest value, it is a solid investment with a history of dividend growth. The company's responsible use of leverage, growth strategy, and income-producing qualities make it a good target for dividend-growth investors.

W.P. Carey, Inc. (WPC)

W.P. Carey is another net-lease REIT and operates in a manner akin to STORE. W.P. Carey owns nearly 1,170 operationally critical real estate locations, including single-tenant industrial, warehouse, office and retail. Its properties feature long-term leases and built-in rent escalators that guarantee future rate increases. The company's operations are primarily in the U.S., but there are substantial holdings in Europe.

Source: 1Q Investor Presentation

The dividend with WPC is more in line with what I want in my REIT. At 4.88%, it is more than double the S&P 500 average and the ten-year Treasury. The dividend payout ratio is getting up there at 80%, but still in the acceptable range for a REIT. The best part about the dividend is that, along with the great yield, there is an expectation for future increases built-in. The company has been increasing its distribution annually for 18 years and is expecting FFO growth so no reason not to expect a dividend increase.

Within the last month, over $120 million in new investments were announced which leads me to think next year's consensus FFO is too low. The first press release included a host of investments not limited to some manufacturing space along I-40 in Statesville, NC. The second press release announced the $70 million lease-back of food production and distribution infrastructure in the Northwest.

WPC has by far the highest value of the diversified/specialized REITs at 18.36X forward FFO. That said, the company is delivering growth and dividend growth with a near 5.0% yield with a healthy balance sheet. Liabilities are about half total assets, cash and cash flow are strong so the dividend should be too.

Source: Investor Presentation

EPR Properties (EPR)

EPR Properties is a specialty REIT investing in select market segments that require industry-specific knowledge and yet offer an attractive, stable return. The three main focus of investment are Recreation, Education, and Entertainment. The company owns over 160 megaplex movie theaters, 34 golf entertainment complexes, 12 ski areas, 20 water parks, and 70 early education/childcare centers, among others.

Source: EPRKC.com

If not for the high payout ratio, this REIT would be a smoking buy right now. The yield is over 6.0%, there's a decade of distribution increases, a decent distribution growth rate, and a low valuation relative to the other specialty REITs. The payout ratio is high at 89%, but I might be able to overlook that in favor of 6.0% yield.

FFO is expected to fall from the previous quarter and last year at the next report. That said, the outlook for this year and next is for FFO growth so I am optimistic the dividend is safe at these levels if not of future increases. The company just got (about a month ago) a downgrade from BofA citing past growth and potential for future returns. The stock has trimmed more than 6.0% off its price since then and is now offering up an attractive entry. The next earnings release is at the end of the month.

Brookfield Property REIT (BPR)

Brookfield Property REIT has only been around for about a year, but that doesn't tell the true story. The REIT is a publicly-traded subsidiary of Brookfield Property Partners (BPY) and built to mimic the overall performance of that company. At $1.73 billion market cap, it is worth about 22% of its parent. What Brookfield Property REIT has going for it is the over 100 years of real asset investing and management experience offered by the parent company.

Something else BPR has going for it are its metrics. The REIT has the highest yield of any on my radar, a history of distribution increase, a double-digit growth rate, positive outlook for FFO growth, and the lowest valuation of any REIT on the list. The only downside is the high payout ratio, but even that is only 0.1% above my threshold and the parent company is paying out closer to 75%, there is some leeway here.

Brookfield is acquisitive but tends to be a little choosier than most. During the last quarter, the company acquired 15 new assets, but that was offset by the sale of 21 others.

The Bottom Line

While the earnings outlook for the broad market deteriorates, the outlook for U.S. real estate is steady, stable growth. The diversified REITs are a good way to gain exposure to that growth and earn a nice return at the same time. The average 4%+ yield that can be found among REITs is attractive in its own right, higher than the broad market or ten-year Treasury, and in many cases, compounded by positive dividend-growth outlook. If you are looking for steady returns in today's uncertain market, I think the REITs on my list all have something to offer, some more than others.

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.