REIT Rankings: Cell Towers
In our REIT Rankings series, we introduce and update readers to each of the commercial and residential real estate sectors. We analyze REITs within the sectors based on both common and unique valuation metrics, presenting investors with numerous options that fit their own investing style and risk/return objectives. We update these rankings every quarter with new developments.
Cell Tower Sector Overview
Cell tower REITs comprise roughly 10% of the REIT ETFs (VNQ and IYR). Within the Hoya Capital Cell Tower REIT Index, we track the four cell tower REITs which account for roughly $175 billion in market value: American Tower (AMT), Crown Castle (CCI), SBA Communications (SBAC) and Uniti Group (UNIT). While cell towers only constitute a tiny portion of total real estate asset value in the United States, cell towers constitute disproportionately high importance in the market capitalization-weighted investible real estate indexes with American Tower and Crown Castle as the two single largest REITs. Investors seeking focused exposure to this sector should consider the Benchmark Data & Infrastructure Real Estate ETF (SRVR), which also includes exposure to the Data Center REIT sector.
Cell Tower REITs primarily own "macro" communications towers that host cellular network broadcast equipment from AT&T (T), Verizon (VZ), T-Mobile (TMUS), and Sprint (S), but Crown Castle and Uniti Group also have significant investments in fiber and small-cell networks. American Tower and SBA Communications focus on macro tower sites, but each also has significant international operations. Typically viewed as growth-oriented REITs that pay relatively low dividend yields but command superior growth profiles, cell tower REITs are among the newest REIT sector, emerging after American Tower converted to a REIT in 2012 followed by Crown Castle in 2013 and SBA Communication in 2017.
Cell Tower REITs have been among the best-performing sectors over the past four years, powered by the network densification required by the early stages of the 5G rollout. More than any other real estate sector, cell tower ownership is highly concentrated. Cell tower REITs own roughly 50-80% of the 100-150k investment-grade macro cell towers in the United States and due to this market power and significant barriers to entry, are perhaps the only real estate sector that could be classified as true price makers rather than price takers.
Consumers want both speed and mobility, but because of the physics and economics of data transmission, there is often a tradeoff between the two. For pure speed and low-latency, a robust fiber-based or dense 5G small-cell network is ideal. This requires laying thousands of miles of underground cables and/or having hundreds of thousands of small-cell base stations using high-band spectrum. For pure mobility, a wide-reaching macro cellular network using high-powered transmitters at lower and farther-reaching spectrum is ideal. This requires having a network of macro towers, but each tower is capable of servicing tens of thousands of devices each, rather than several dozen or hundreds of customer per small-cell antenna. Since consumers need both speed and mobility and none of the players are able to fully satisfy both of these needs, a blend of different technologies- including macro cell networks- will continue to be used to meet the growing demand for data connectivity.
(Source: American Tower Investor Presentation)
Cell tower REITs continue to command strong competitive positioning in the telecommunications sector. Cell carriers sold off their tower assets beginning in the mid-2000s to de-lever their balance sheet and free-up capital to expand their networks. Supply growth is almost non-existent in the US as there are significant barriers to entry through the local permitting process and due to the economics of colocation versus building single-tenant towers. The relative scarcity of cell towers, combined with the absolute necessity of these towers for cell networks, has given these REITs substantial pricing power even as the number of potential tenants has dwindled down to just four national carriers over the last two decades. The equity sector that we think has the most upside potential from the growth of wireless communications and the 5G revolution, cell tower REITs have benefited from the increase in network spending from the four national carriers during the early stages of the 5G rollout.
Relative to other real estate sectors and their cellular carrier tenants, cell tower ownership is a high margin business with significant operating leverage driven by upgrading adding additional multiple tenants to existing towers. EBITDA margins typically average around 60-65% for the sector, towards the higher-end of the real estate universe. Multiple tenants typically lease space on the cell tower with rental rates based on property location and the amount of equipment on the tower or on the ground site below. Cell tower leases are typically 5-10 years with annual fixed-rate escalators with multiple renewal options. Cell tower REITs only own about one-third of the land under the towers and control the rest through long-term ground leases, a source of potential long-term risk.
It's almost a done deal. In an announcement last week, the US Department of Justice indicated that it would approve the long-anticipated merger between the third and fourth-largest US wireless carriers, Sprint and T-Mobile. An unexpected coup for cell tower REITs who risked losing one of the four possible tenants, the approval is conditional on the facilitated creation of a fourth competitor. As it currently stands, revenues from Sprint and T-Mobile comprise a combined 26% of total industry revenues, but the “overlap” between Sprint and T-Mobile cell tower sites is roughly 4% of total industry revenues.
As we discussed in our last update, there was much debate over the long-term competitive dynamics under different merger scenarios (none of which involved the creation of a fourth competitor), including the possibility that an outright rejection of the merger may lead to an even less desirable competitive dynamic in which Sprint and T-Mobile's lag further behind, lacking the capital needed for a full 5G rollout to keep up with AT&T and Sprint, leading to an effective duopoly in the wireless space.
We postulated that cell tower REIT investors should probably be rooting for a merger approval with that caveat that a "best case" alternative would be that a well-capitalized and motivated partner emerged to "rescue" Sprint including Comcast (CMCSA), Charter (CHTR), Amazon (AMZN), Apple (NASDAQ:AAPL), or Google (GOOG). As it currently stands pre-merger, Sprint and T-Mobile lag significantly behind in the all-important postpaid phone category but have sizable market share in the lower-value prepaid category.
While cell tower REITs have been bid-up on merger optimism, Dish Network's (DISH) viability as a national carrier is an unknown wildcard. Dish, which has acquired rights to of billions of dollars in wireless spectrum over the past decade and has roughly 12 million TV subscribers, would acquire Sprint's 9 million prepaid customers for $1.4 billion. Additionally, T-Mobile would be required to offer wholesale services to Dish for seven years, allowing Dish customers to utilize the full T-Mobile/Sprint network. Dish, however, cannot sell its wireless business or newly acquired assets to a third party for at least three years.
As part of the agreement, Dish would effectively promise to make good on its ambitious proposal to cover 70% of the population with a 5G network by June 2023, a rollout that Dish estimates would cost $10 billion, but that analysts believe will cost many multiples more considering that Verizon and AT&T spend roughly $15-20B per year simply upgrading their existing national network. We estimate that a true national buildout of this magnitude would require closer to $50-75B over the next five years. If the deal does indeed go through as-is, the wireless market would be comprised of three roughly equal competitors with a distant, upstart fourth.
One key hurdle remains for the proposed $27B deal, as more than a dozen state AGs are engaged in a lawsuit to block the deal, citing concerns over reduced competition. These AGs, along with many analysts and industry observers, are skeptical that Dish is truly a viable long-term competitor considering its already burdensome debt load and lack of operational expertise in managing a national wireless network. Particularly scrutinized are the stipulations that limit Dish's ability to partner with a third-party, presumably written by T-Mobile's negotiation team to prevent the likes of Amazon, Apple, or Google from seizing the opportunity to enter the wireless space.
The situation remains fluid and cell tower REIT investors are holding out hope that the viability of Dish can be enhanced by additional concessions. As we explained in our last update, evaluating the impact of different merger scenarios on cell tower REITs on the proliferation of 5G requires making forecasts and assumptions that are anything but certain. To help evaluate the impact on cell tower REITs and 5G, we detail four possible scenarios.
Scenario 1: Merger Approved As-Is, But Dish Can't Find A Partner
The cellular carrier industry would be consolidated into three players of roughly equal size with a distant fourth competitor that lacks the financial or operational ability to run a national network. Limited in their ability to partner with a third-party and restricted by the terms of the concessions from T-Mobile and Sprint, Dish becomes a niche player and is unable to fulfill their promise of 70% coverage by 2023, choosing instead to pay the fine to the US government. However, with more balance sheet capacity, the merged T-Mobile ramps up network spending in line with Verizon and AT&T, which would translate into an immediate boost to cell tower REIT revenues. With one less competitor, the 5G rollout begins sooner but is focused on higher-value markets and consumer pricing would likely become marginally less competitive, translating into higher margins for carriers, but potentially fueling further network investment. Over time, however, the competitive positioning of cell tower REITs would be slightly diminished. Carrier initiatives to gain leverage over cell tower REITs, including building their own towers or taking over ground leases from REITs, would be incrementally more successful and growth would moderate but remain at above-inflation levels due to the still-favorable competitive positioning.
Probability: 45%. For Cell Tower REITs: Decent/Default Outcome.
Scenario 2: Merger Approved, Dish Finds A Partner
To get final approval from the state AG's, T-Mobile agrees to further concessions that would make sure Dish has a fighting chance. This would likely involve removing the limits on Dish's partnership ability or sale of assets and potentially granting more extensive access to the T-Mobile network. An outcome that the carriers hope to avoid but that cell tower REITs investors are cheering for, Dish finds a partner in Comcast, Charter, Amazon, Google, or Apple and the entity quickly becomes a legitimate fourth competitor in the wireless carrier space. The well-capitalized carriers battle to become leaders in 5G and access is widespread and pricing remains competitive. Initiatives to gain leverage over cell tower REITs are largely unsuccessful and pricing power for cell tower REITs remains strong.
Probability 35%. For Cell Tower REITs: Best Outcome.
Scenario 3: Merger Rejected – Sprint Finds A Partner
The merger gets rejected, but as Dish was seeking to do, Sprint is able to find a suitor or partner. Sprint's underpriced and valuable network and spectrum assets are attractive to cable broadband providers who recognize the mounting and legitimate threat from 5G fixed wireless broadband, which we believe to be underappreciated by the market. Alternatively, a cash-flush technology company sees the assets as an underpriced complement to their existing data center infrastructure and a new source of distribution to mitigate the competitive threats from the incumbent broadband providers. Sprint is able to leverage this partnership to become a legitimate competitor in the space. Meanwhile, T-Mobile continues its strong run of adding customers at sector-leading rates. The carrier industry remains at four players with T-Mobile and Sprint close behind and consumer pricing competition remains strong. The four carriers battle to become leaders in 5G and access is widespread. Initiatives to gain leverage over cell tower REITs are largely unsuccessful and pricing power remains strong.
Probability 10%. For Cell Tower REITs: Very Good Outcome
Scenario 4: Merger Rejected – Sprint Fails
The merger gets rejected Sprint is unable to find a suitable partner. Sprint's investors, including SoftBank, scale back their investment and the network falls further behind the other three carriers and continues to lose customers until being unable to operate any longer. In bankruptcy, Sprint's assets are distributed around the telecom sector including to AT&T and Verizon, further strengthening their grip on the emerging duopoly. T-Mobile's strong run of performance slows down and cannot keep up with the network spending of the two major players without the complementary asset of Sprint. The carrier industry becomes a de facto duopoly and cell tower REIT competitive positioning is significantly diminished. Consumer pricing becomes significantly less competitive and the 5G rollout continues but is isolated only to the most high-margin deployments. Carrier initiatives to gain leverage over tower REITs are largely successful and the industry becomes more akin to the data center REIT sector over the past several years with below-inflation internal growth rates and weak pricing power over increasingly dominant tenants.
Probability 10%. For Cell Tower REITs: Worst Outcome.
In summary, for cell tower REITs, four competitors is better than three, but three definitely beats two. The way that we see it is that even if Dish’s ambitious plans fail to materialize, a strong combined T-Mobile avoids a possible duopoly, which would be a worst-case outcome for cell tower REITs, cell customers, and the proliferation of 5G. Many pieces have to fall into place for there to be four viable wireless network competitors in the United States, but that probability is greatly enhanced if the expected growth of additional applications for cell-based wireless networks come to fruition including fixed wireless broadband and the Internet of Things.
As discussed in our last update, we believe that fixed wireless broadband will be the true "killer app" for 5G that could take significant market share away from traditional cable broadband providers. If indeed these carriers can make inroads into the home broadband business, there is no reason that industry revenues could not support four or more competitors. The question is: will four carriers be around long enough to realize that secular tailwind?
Cell Tower REIT Fundamentals
Beneath the noise of the merger frenzy, cell tower REITs delivered another stellar second quarter. All three cell tower REITs beat AFFO estimates and raised full-year AFFO per share guidance as the early effects of network densification to fuel 5G networks powered above-trend organic growth. Organic tower revenue, effectively the same-store NOI equivalent, continues to grow at a sector-leading 6%+ rate as carriers continue to invest heavily in network densification and equipment upgrades. With the high degree of operating leverage inherent with the colocation tower model, tower REITs are seeing amplified benefits increased network spending.
After boosting guidance, AFFO per share growth is now expected to average 10.0% growth in 2019, the highest in the REIT sector. As Crown Castle noted in their earnings call:
“Current tower leasing activity is our highest in more than a decade which we expect will carry into next year. We are seeing a more significant acceleration in tower leasing this year than we previously expected with broad demand from each of our largest customers as they deploy additional cell sites and spectrum in response to the rapid growth in mobile data traffic.”
As it relates to the merger, American Tower provided their first on-the-record reactions to the recent news on this quarter's earnings calls. American Tower was understandably excited about the potential for a fourth potential tenant on its potential acceleration of the 5G rollout. From the American Tower earnings call:
“The agreement really positions the US to accelerate its achievement of global leadership in 5G technology, while at the same time retaining a competitive industry structure that benefits consumers. I believe this will be an excellent environment for American Tower, especially with the increasing focus that you've heard about recently on low and mid-band spectrum for 5G, especially from the Sprint, T-Mobile sides of the equation, not to mention Dish, just last week Verizon, and of course, AT&T has been talking about this already.
Along with robust organic growth, external growth via strategic acquisitions remains a central focus of cell tower REITs, aided by the cost of capital advantage enjoyed by these firms. As we'll discuss shortly, cell tower REITs trade at an estimated 20-30% premium to private market-implied net asset values, meaning that external acquisitions, though somewhat limited, are easily accretive to earnings. The combination of strong organic growth and continued external growth fueled a 16% rise in total property revenues in 2018, rising from the 13% rate achieved in 2017, boosted by the effects of Crown Castle's merger with small-cell operator Lightower. While appearing to be very conservative, these REITs offered guidance that projects a 6% rise in property revenues in 2019.
While the tower business remains as strong as ever, small cell deployment has been slower than anticipated, held back by local regulatory hurdles. As Crown Castle noted in their earnings call:
"The significant increase in the volume of small cells being constructed is straining the response times from municipalities and utilities who are not complying with the FCC orders, resulting in longer construction timelines than we previously experienced.”
Bull & Bear Thesis for Cell Tower REITs
To that point, we continue to believe that macro cell towers provide the most economical mix of network coverage and capacity, and recent challenges with dense small-cell network deployment have affirmed our belief that macro towers will continue to be the "hub" of next-generation networks for the foreseeable future. While communications technology does change very rapidly, it appears that the physical and economic limitations of the alternative technologies (low-orbit satellites, wide-spread small cell networks, and outdoor Wifi) are unlikely to abate anytime soon and the risk of technological obsolescence in the 5G-era is often overstated. While cell carriers have tried to make moves to establish leverage over tower owners by building or acquiring towers themselves, carriers have limited available capital to spend on these initiatives, especially in light of the capital-intensive 5G rollout.
The four-year run of strong performance, however, has pushed cell tower REIT valuations to elevated levels compared with the rest of the real estate sector. The land under cell towers, of course, is worth very little without a functioning macro cell site. While we don’t believe there is an immediate risk of technological obsolesce, it is impossible to predict technological innovation in a decade, much less over multiple decades. Further, carriers are incentivized to invest capital in alternative technologies like small-cells and DAS to try to reduce the competitive position of cell towers. Perhaps the most significant risk relates to the fact that these REITs own just 30% of the land under their structures and lease the other 70% through (typically long-term) ground leases.
Cell Tower REIT Stock Performance
Trailing only the industrial sector, cell tower REITs have been the stand-outs yet again in 2019, on pace to outperform the REIT index average for the fifth straight year. Surging more than 33% so far this year, only the manufactured housing sector - which is on pace for seven years of consecutive outperformance - has a longer streak of outperformance. SBA Communications has led the way so far this year, jumping more than 50%, followed by American Tower at nearly 35% gains. The gains are not shared by all, however. Uniti Group, continuing to deal with the fall-out of the Windstream bankruptcy, has plunged by more than 40% this year.
Since NAREIT began tracking the sector in 2012, cell tower REITs have outperformed the REIT index in every year besides 2014. Cell towers continue to be one of the few remaining growth engines of the REIT sector and, considering the positive operating environment forecast for 2018-2020, don't appear to be slowing down anytime soon.
Valuation of Cell Tower REITs
Strong performance over the past four years has pushed cell tower REIT valuations towards the most expensive end of the real estate sector. Cell towers trade at a sizable Free Cash Flow premium (aka AFFO, FAD, CAD) to the REIT average, but after accounting for the sector-leading expected growth rates, cell tower REITs very quite attractively valued based on the FCF/G metric. As discussed above, cell tower REITs trade at some of the widest NAV premiums in the real estate sector, giving these companies the "cheap" equity capital to fuel further external growth.
Cell Tower REIT Dividend Yield
Cell tower REITs are among the lowest-yielding REIT sectors, paying out just 65% of their free cash flow and instead of plowing that capital back into the business to fuel external growth. The sector pays an average 1.9% dividend yield, among the lowest among REITs.
Within the sector, only Crown Castle acts like a typical REIT when it comes to distributions. CCI pays a healthy 3.4% dividend yield, while AMT pays 1.6%.
Cell Tower REITs & Interest Rates
Cell tower REITs skew towards the "growth" side of the real estate sector, reacting more to economic growth expectations than to changes in interest rates. Among US REIT sectors, cell towers are the fourth least interest rate sensitive sector and could provide balance to an otherwise rate-sensitive REIT portfolio.
Within the sector, AMT and SBAC are classified as Growth REITs. CCI, which pays a 4% dividend, is a Hybrid REIT and has characteristics that are more aligned with the REIT averages. We classify Uniti as a "speculative growth" REIT and is suitable only for investors willing to take on high risk of principal loss.
The long-anticipated marriage between T-Mobile and Sprint appears more certain than ever after clearing regulatory hurdles from DOJ and FCC, setting-up a final battle with state attorney generals. An unexpected coup for cell tower REITs, the approval is conditional on the facilitated creation of a fourth competitor. Dish’s viability as a national carrier, however, is an unknown wildcard.
For cell tower REITs, four competitors are better than three, and three beats two. Even if Dish’s ambitious plans fail to materialize, a strong combined T-Mobile avoids a possible duopoly. Dish needs a well-capitalized partner or acquirer to have any real shot at success, something that T-Mobile negotiators have walked a tight-rope with regulators to try to prevent.
Powered by the network densification required by the early roll-out of 5G, cell tower fundamentals remain white-hot. All three cell tower REITs beat AFFO estimates and raised full-year AFFO per share guidance as the early effects of network densification to fuel 5G networks powered above-trend organic growth. We discussed four possible merger scenarios and their impact on the sector, concluding that cell tower REIT investors should be happy with three viable competitors, ecstatic at the potential four, but worried about the possibility of two.
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Disclosure: I am/we are long VNQ, AMT, AMZN, GOOG, AAPL. 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.
Additional disclosure: It is not possible to invest directly in an index. Index performance cited in this commentary does not reflect the performance of any fund or other account managed or serviced by Hoya Capital Real Estate. All commentary published by Hoya Capital Real Estate is available free of charge and is for informational purposes only and is not intended as investment advice. Data quoted represents past performance, which is no guarantee of future results. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy.
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