Why REITs Outperform Stocks And 3 'Strong Buys' Heading Into H2 2019

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Includes: AMZN, BDC, GOOG, JCAP, MNR, NFLX, RESI, VNQ
by: Jussi Askola
Summary

There are real structural reasons why REITs outperform Stocks in the long run.

After a multi-year period of underperformance, REITs are now just getting back to their former glory.

We present three lesser-known small caps in which we currently invest as part of our Core Portfolio.

Over long time periods, REITs have consistently produced much greater returns than Stocks:

Investors who missed out on these gains try to rationalize by saying this outperformance was a “fluke” or a “one-time-event” that won’t reproduce itself in the future.

We strongly disagree. In fact, we believe that the outperformance of REITs (relative to Stocks) is very much expected – and the reasons that led to outperformance in the past remain perfectly relevant today. Any asset class can outperform over a 1-year or even 5-year time period, but you don’t come ahead for decades and decades by pure luck.

Also, contrary to popular belief, the REIT sector valuations remain very reasonable today and there still exists roughly 20 undervalued opportunities in which you should consider investing.

Below we present:

  • Three reasons why REITs outperform Stocks in the Long Run
  • Why REITs are reasonably priced right now
  • 3 Lesser-Known REIT Recommendations from High Yield Landlord.

Three Reasons Why REITs outperform Stocks in the Long Run

Reason #1 - Real Estate is an Alpha-Rich Asset Class

We strongly believe that real estate is the very best asset class to generate high total returns over long time periods. Still to this day, you can:

  • Buy properties at a 6-7% cap rate
  • Finance half of the purchase with a 3-4% mortgage
  • Appreciates at 2-3% per year (along with income growth)

And you get close to 12-15% annual total returns. It is this simple. The assumptions are nothing unrealistic and this is done every day by experienced property investors. Since REITs are nothing more than actively managed baskets of real estate investments, the results of REITs should not greatly differ from those of private real estate investments.

Reason #2 – Powerful Tax Savings

Unlike regular corporations (stocks) which pay corporate taxes on their net income; REITs are tax-advantaged vehicles and do not pay any corporate income tax.

This alone may account to a 20% income advantage right off the bat. Assuming that two businesses are equally viable, but one is structured as a REIT and the other as a normal C-corp, the REIT will generate greater returns by simply saving significant taxes.

Reason #3 – Forced Dividend Payment

REITs must, by law, pay out 90% of their taxable income in the form of dividends to shareholders. This often-overlooked rule creates alpha by removing conflicts of interest and improving the discipline over capital allocation.

Since managers do not have a lot of cash flow to play with; they are less likely to waste it on some low ROI projects. Rather, they will often have to access the public markets to raise new equity under the scrutiny of professional analysts.

Research studies have found that dividends make up a very large portion of total returns and dividend-paying stocks consistently outperform others.

REIT Market Valuation in August of 2019

The REIT market has been on a very strong run since the start of the year. The Vanguard REIT ETF (VNQ) is up by 23% in just half a year:

As a result of this strong performance, investors are led to believe that REITs are now overpriced and posed for poor returns. In reality, this large surge in share prices is coming after 3-years of disappointing returns with only ~5% annual returns.

Therefore, REIT valuations have actually fallen behind when you compare to broader equity market indexes. The S&P500 trades currently at 22x earnings – a 30% premium to its historic average. REITs trade at roughly 19x FFO – close to its historic mean. Sure there are some REITs that trade at expensive multiples – but nothing that comes even close to companies like Amazon (AMZN) or Netflix (NFLX).

Moreover, undervalued opportunities remain abundant in the small-cap segment of the REIT market. This is because most of the index money has flown straight to the large caps and pushed their FFO multiples to new highs - while smaller caps were left behind at closer to 12x FFO.

The difference in small-cap vs. large-cap REIT valuations has rarely been this large… and creates an opportunity for active REIT investors.

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This is where we are investing today. Our Core Portfolio has a dividend yield of 7.75% with a 69% payout ratio despite a yield that's almost double the REIT indexes (VNQ). Beyond the dividends, the core holdings are trading substantially below intrinsic value at just 9.5x FFO - providing both margin of safety and capital appreciation potential:

From this angle, do REITs still look overvalued to you? Is it too late to invest in REITs? We do not believe so!

Three HYL Recommended REITs

Our REIT portfolio holds today 20 positions with many names trading at their lowest valuations in years. We consider these to be massively undervalued by the market and expect significant upside in the coming years. Here are three examples in which we are currently investing:

Company

Rating

Risk Level

Allocation Level

Monmouth

STRONG BUY

Low

Large

Monmouth (MNR) is an industrial REIT that recently traded down for reasons that we believe to be unwarranted. As a result, the company has become undervalued at just 14x FFO while its closest peers trade at 22x FFO on average. The investment operations are very conservative and perfectly positioned in a late cycle economy with long lease terms, investment grade tenants, and exceptionally long debt maturities. The current dividend yield is 5% and investors can sleep well at night knowing that MNR has never missed a single dividend payment in its multi-decade history. Combined with 5-10% FFO Growth and some FFO multiple expansion, we expect MNR to continue its streak of market outperformance.

Company

Rating

Risk Level

Allocation Level

Jernigan Capital

STRONG BUY

High

Large

Jernigan Capital (JCAP) is a relatively new REIT that provides creative capital solutions to private developers, owners, and operators of self-storage facilities. It is a model that is different from equity REITs, but also from mortgage REITs. In many ways, it gets closer to a business development firm (BDC) as it loans money, receives equity and often provide additional services to borrowers. The results have been phenomenal thus far with very strong returns on invested capital, and the pipeline remains large. Sold at just about 6.8x FFO, we believe that the company is mispriced by at least 40%. While we wait, we earn a well-covered 7.3% dividend yield.

Company

Rating

Risk Level

Allocation Level

Front Yard Residential

STRONG BUY

Avg

Avg

Front Yard Residential (RESI) is our deep value pick among single family rental REITs. The company own a well-diversified portfolio of affordable rentals and trades at an estimated 35% discount to NAV. It pays an attractive 4.8% dividend yield and we expect double digit annual returns as the company closes down its excessive discount to NAV.

Closing Notes

These three REITs have four things in common:

  • They trade at deep discounts to NAV and low FFO multiples.
  • They pay high dividends that are expected to grow in the long run.
  • They have ample near-term upside potential.
  • There exists clear catalysts for value realization.

Our Portfolio at High Yield Landlord is made of investments like these three. We aim to buy Real Estate at a discount to fair value to fund our 8% target yield. It's just common sense that buying real estate for materially less than what it's worth is a strategy for superior long term results.

By investing in passive indexes, we believe that REIT investors are set to outperform Stocks. However, by being selective, we believe that returns can be improved even further. The best REIT investors have achieved up to 22% annual returns over the past decades.

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Disclosure: I am/we are long JCAP, MNR, RESI. 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.