Small-Cap REITs Are Hard To Beat

|
Includes: ABR, CHCT, CIO, CORR, CTT, HASI, IRET, IRT, LMRK, STAG, VNQ
by: Brad Thomas
Summary

The Small Cap REIT portfolio that has returned about 23% year to date.

Since inception (January 2016), the Small Cap REIT portfolio has outperformed the Vanguard Real Estate ETF by almost four times: 37.7% compared with 9.3%.

Take a look at these top 10 small-cap REIT performers year to date.

Looking over my homepage on Seeking Alpha, it appears I haven’t intentionally, directly focused on small-caps REITs – real estate investment trusts – on this site for a few months.

It’s true that I’ve mentioned some here and some there in list-filled articles. And some people might point out the “Global Self Storage: a Nanocap REIT That’s Poised to Profit” piece I published last month. But, as the title suggests, that one was about nanocaps, not small caps.

There’s a difference. Just because a company doesn’t make it onto the Fortune 500 list doesn’t mean it’s “all the same” as any other non-Fortune 500 entity.

We classify these businesses as we do for a reason: to better understand them and whether they’re right for us. So here are the official definitions of the three main profit grades, courtesy of Investopedia:

  • Nanocaps are “small, publicly traded companies with a market capitalization below $50 million.”
  • Small caps are “stocks with a market cap between $250 million and $2 billion.”
  • Mid-caps are “companies with a market capitalization (value) between $2 and $10 billion.”
  • Large caps are companies “with a market cap of more than $10 billion.”

(For the record, microcaps fit in between nanocaps and small caps.)

Clearly then, there are some big and bigger fish to fry out there in the markets. But that doesn’t mean you should throw back everything else that swims along.

There are plenty of smaller fins out there that taste just as good – maybe even better.

Plus, let’s face it, they’re often easier (read: cheaper) to catch. And who doesn’t like a bargain?

A hand holding a frogDescription automatically generated

Photo Source

The Argument Against Small Caps

You know how not everything that glitters is gold? Well, not everything that’s doesn’t glitter is worthless.

Are some small-cap companies pointless and perhaps even downright dangerous? Of course. You’ll get no argument from me there.

By their very nature, these businesses can be less proven than I’d like. More often than not, they have the market caps they do because they haven’t been around long enough. And in not being around long enough, they haven’t made enough.

Nor have they established a long enough track record.

Let’s say you’re looking at small-cap company AYOR (apparently a texting abbreviation for “at your own risk”). AYOR went public in 2016, going on to have a banner year in 2017 and another banner year in 2018.

Based on that information alone, should you buy into it, expecting 2019 to end the same way? What can you conclude?

Well, really, probably not that much. Even the smartest, most savvy investor out there can only make so many worthwhile predictions from that exceptionally limited data.

For one thing, the company in question may have had two banner years in a row because the whole economy had banner years. Or because of a two-year fad. Or because of an initially awesome marketing effort from a designated fund that has since dwindled – and not been properly paid back.

Or it could be because the business has a solid management team, dedicated employees, and an outstanding product or service it’s selling.

With that limited data, it’s impossible to tell.

The Argument for Small Caps

Let’s acknowledge reality and, in the process, expand the perimeters we laid out above. Because investors are very rarely, if ever, left with as little information as we granted in that initial scenario. They don’t operate in a vacuum, analyzing a publicly traded entity’s financials without being able to analyze macroeconomic data at the same time.

Investors therefore know that the markets swept upward at an unprecedented pace in 2017, meandered and even fell a bit in 2018, and were up for the first half of 2019. (Who knows about the second half?)

That’s good! There’s more to analyze. But there’s still not much to go on concerning management or trends. Perhaps the guys and gals in charge did perfectly well during their pre-IPO days. But they’re swimming with sharks now.

Can they keep up?

That’s the question. And the fact that the answer isn’t assured – or as assured as a business can be – means there’s greater risk.

But the trade-off for that risk can be well worth the cost. If your breakdown of the company’s limited financials seem to give you a greenish light (maybe a chartreuse one?) that almost assuredly means you’re buying up a lower-priced stock.

That lower-priced stock has greater room to grow should everything work out the way you predict. As the company strengthens its track record, its share value should increase as well.

And so should your profits.

Better yet, when you’re talking about a REIT, you get an added level of assurance that the company isn’t going to collapse. REITs are designed to be pretty solid. Plus, you get paid dividends as you go along.

That’s the case for investing in small-cap REITs in general. Now here’s why I like the following picks in particular.

These Small-Cap REITs Are Intriguing

Our marketplace service, iREIT on Alpha, has five different portfolios, and the top-performing portfolio is the Small Cap REIT portfolio that has returned around 23% year to date. Over the last 12 months, the Small Cap REIT portfolio has returned 19.6% (versus Vanguard Real Estate ETF (VNQ), which has returned 14.6%). Since inception (January 2016), the Small Cap REIT portfolio has outperformed the VNQ by almost four times: 37.7% compared with 9.3%.

A close up of a mapDescription automatically generated

Source: iREIT

Much of the success of our small-cap portfolio has been research. We spend a lot of time studying these less-noticed names in hopes of generating optimal returns. As mentioned earlier, many of the small caps don’t have track records or analyst coverage, so we do most of the hard work, and believe me, it pays off. Just take a look at our top-performing small-cap REITs (based on year-to-date performance):

A screenshot of a cell phoneDescription automatically generated

Source: iREIT

Let’s take a closer look at these top 10 names:

STAG Industrial (STAG) is our largest small cap, and arguably with a market cap of $3.7 billion, this industrial REIT can also be considered a mid-cap. We have been covering the company since 2011, when it was a true small cap and the dividend yield (then) was over 10%. These days, STAG has earned its way on to our coveted SWAN list and we attribute much of the success to growing earnings (or FFO) and dividends, while also reducing the payout ratio. Give the rapid price appreciation year to date, we have a HOLD on STAG now, but we’re happy to own the shares given the respectable Q2-19 performance and strong growth forecasted (around 6%) in 2020. STAG’s P/FFO multiple of 16.4x is 9% higher than the company’s normal (five-year) P/FFO of 14.9x. Year-to-Date Total Return: +26.4%

A screenshot of a social media postDescription automatically generated

Source: FAST Graphs

CorEnergy (CORR) is an infrastructure REIT that invests in critical-mission midstream and downstream real estate assets within the U.S. energy sector. The company’s revenue stream is resilient and protected even during bankruptcy. We upgraded the company to a strong buy late last year and we have been pleased with the performance (+26.5% YTD). The company has ample liquidity to acquire new assets (has $60 million in cash and $120 million on the revolver) and we suspect the company will put its dry powder to work this year. Shares are now trading at 14.5x P/AFFO, around 28% higher than the normal range (of 10.4x). We are maintaining a HOLD given the price run-up: Year-to-Date Total Return: +26.5%

A close up of a piece of paperDescription automatically generated

Source: FAST Graphs

Arbor Realty Trust (ABR) is a specialty finance platform that invests in a diversified portfolio of structured finance assets in the multifamily and commercial real estate markets. We include the company in our commercial mortgage REIT peer set and the FAST Graph below uses core earnings, instead of funds from operations. The company’s primary focus is multifamily and senior loans, which generate strong leveraged returns, and has maintained a steady and reliable dividend growth. In May 2019 we reiterated our buy rating with a year-end target price of $14.25. The dividend is well covered and in the latest quarter (Q2-19) the company increase its quarterly dividend to $0.29 a share, which represents the second increase this year and reflects annual run rate of $1.16 per share, up from $1.08 per share. Arbor is trading at +19% above its normal P/E and the current dividend yield is 9.2%. Year-to-Date Total Return: +30.7%. A screenshot of a social media postDescription automatically generated

Source: FAST Graphs

City Office (CIO) is a small-cap office REIT that specializes in secondary markets such as San Diego, Seattle, Portland, Boise, Phoenix, Salt Lake City, Denver, Dallas, San Antonio, Austin, Houston, Tampa, and Orlando. The company invests in high-quality office properties in midsized metropolitan areas with strong economic fundamentals, primarily in the southern and western United States. We picked up coverage in 2016 and in our latest article (March 2019) I said that “2019 could be the year in which City Office become a prime-time REIT that’s poised to profit”. Our strong buy thesis is rooted in City Office growing out of its elevated payout ratio and in the latest quarter (Q2-19) the company reported core FFO of $13.7 million or $0.34 per share, $1.9 million higher than Q1-19. The goal for a strong buy upgrade is for 25% annualized returns, and thus far in 2019 City Office has returned over 32%. Some analysts have been skeptical of City Office’s payout ratio, yet the company is debunking the “sucker yield” name calling and Mr. Market agrees. Year-to-Date Total Return: +32.9%.

A screenshot of a social media postDescription automatically generated

Source: FAST Graphs

Independence Realty Trust (IRT) is an apartment REIT that focused on Class B properties with attractive rental dynamics. A few things attracted us to this name, including the geographic focus (southeast and Rust Belt markets), reduced leverage (from 68% to 50%), and growing earnings stream (quadrupled since 2014). Keep in mind that we look small cap REITs that are mispriced and based on the rapid price appreciation of IRT, we have exited the position and maintain a HOLD. Shares now trade at 20.3x P/FFO, over 30% higher than the normal range (of 14.3x) and we’re also becoming worried that the company could cut the dividend, and we see limited prospects for dividend growth in 2020 and 2021. Year-to-Date Total Return: +33.2%.

A screenshot of a social media postDescription automatically generated

Source: FAST Graphs

Investors Real Estate (IRET) is now a 100% pure-play multifamily REIT that has successfully transitioned from a diversified platform to a Class B apartment owner. You might recall an article I authored in December 2017 in which I explained that the company’s medical office building portfolio “is the trigger (catalyst) that should simplify the business model while also providing improved financial flexibility” and since that time, IRET has delivered exceptional results. In the latest quarter, the company reported 2.6% same store NOI growth and core FFO growth of +9.9% over Q2-18. The company announced that its FFO/sh increased by 9.3% over six months. We’re glad to see this small cap hitting all-cylinders and given the price appreciation we are maintaining a HOLD. Year-to-Date Total Return: +40.4%

A close up of a mapDescription automatically generated

Source: FAST Graphs

Catchmark Timber (CTT) is a “pure play” Timber REIT, and unlike the peers, Catchmark was not born out of the industrial REIT complex (i.e., paper mills and other forest products) but instead the Atlanta-based company has focused on raw materials only. Another differentiator for this small cap is that the company opts to focus on high-demand southeastern US markets (Mid-Atlantic, Coastal, South Central, and Southwest). You may recall that we maintained a Strong Buy in February 2019, recognizing that “timberland exposure is a great uncorrelated asset play that most portfolios deserve some sort of exposure”. Catchmark’s dividend yield if 5.4% and we still see some value in the name (we maintain a buy) given the discount (-13%) to normal earnings multiples. Year-to-Date Total Return: +44.1%.

A picture containing screenshotDescription automatically generated

Source: FAST Graphs

Community Healthcare (CHCT) is a healthcare REIT that focuses on "smaller ancillary properties in non-urban markets - generally not a hospital or even a large on campus medical office building." The company invests in a wide basket of categories that includes medical office buildings, physician clinics, surgery centers, and hospitals. In addition, the company focuses on individual acquisition opportunities of $10 million or less in off-market or lightly marketed transactions. In my last article (March 2018) I upgrade the company from a HOLD to a BUY and this proved to be an excellent upgrade, especially since we added shares to the small cap REIT portfolio. Shares are now trading at a 19% premium to normal P/FFO (25.9x vs 21.9x), so our current recommendation is a Hold. Year-to-Date Total Return: +47.4%.

A screenshot of a social media postDescription automatically generated

Source: FAST Graphs

Hannon Armstrong (HASI) is a specialty finance REIT that aggregates assets in multiple categories, all pertaining to clean energy real estate projects. You may recall my first article on the company in February 2015 that out shares “front and center” after I explained “forget beaten up utilities (for now), BUY this 7.1% clean energy REIT”. That particular article(171 comments) was well received by the market as shares shot up over 8% and since that time, they have gone virtually straight up. In the latest earnings period (Q2-19) the company announced core earnings of $0.30 per share and reiterated its three-year guidance through 2020 of 2% to 6% growth in core earnings. We have since downgraded HASI to a Hold, recognizing the valuation is stretched (P/E is 20.3x vs 17.1x normal multiple) and the dividend yield is 4.8%. Year-to-Date Total Return: +49.2%.

A screenshot of a social media postDescription automatically generated

Source: FAST Graphs

Landmark Infrastructure (LMRK) is an MLP that invests in operationally essential infrastructure assets. The company serves three masters: wireless communication, outdoor advertising, and renewable power generation industries. Although the company is an MLP, it’s hoping to convert to a REIT platform in the next year or two (the company has a REIT subsidiary now that has eliminated the partnership structure: i.e. issues a 1099). Although we have voiced concerns over the company’s payout ratio, we are big fans of the company’s “smart pole” platform that we consider a “game changer” for the company to generate double-digit returns. Back in November 2018 I said that we expect the company to generate 50% to 75% upside in 12-24 months and guess what? Given the price appreciation, we have moved the company back from a Spec Buy to a Hold. Year-to-Date Total Return: +55.6%.

A screenshot of a social media postDescription automatically generated

Source: FAST Graphs

Stay tuned for my list of five of the hottest small cap REIT "buys" for 2019.

Author's note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: written and distributed only to assist in research while also providing a forum for second-level thinking.

Disclosure: I am/we are long LMRK, HASI, CORR, CTT, IRET, CIO, STAG, ABR. 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.