In our REIT Rankings series, we analyze REITs within each of the commercial and residential sectors, focusing on property-level fundamentals and the macroeconomic forces driving overall supply and demand conditions. We then analyze REITs based on both common and unique valuation metrics, presenting investors with numerous options that fit their own investing style and risk/return objectives.
(Co-Produced with Brad Thomas through iREIT on Alpha)
Within the Hoya Capital Cell Tower REIT Index, we track the four cell tower and wireless infrastructure REITs which account for roughly $170 billion in market value: American Tower (AMT), Crown Castle (CCI), SBA Communications (SBAC) and Uniti Group (UNIT). While cell towers only constitute a fraction of total real estate asset value in the United States, cell tower REITs comprise roughly 10-15% of the broad-based Real Estate ETF (VNQ) due to their high degree of REIT ownership.
Cell tower REITs own roughly 50-80% of the 100-150k investment-grade macro cell towers in the United States. 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. While Crown Castle operates exclusively in the United States, American Tower and SBA Communications have significant international operations. While long-term growth in international markets is expected to outpace domestic growth, it comes with increased risks as well, highlighted by American Tower's significant struggles in India.
Due to this market power and significant barriers to entry in the United States, cell tower REITs are perhaps the only real estate sector that could be classified as true price makers rather than price takers, but there are some concerns that the competitive dynamics could change after the likely merger between T-Mobile and Sprint. The emergence of a fourth competitor - DISH Network (DISH) as a precondition to approval eases some of those concerns, even as questions remain about DISH’s viability as a national competitor. Comcast (CMCSA) and Charter (CHTR) have also made a push in recent years to compete in the cell business, primarily through "renting" capacity from the existing carriers to supplement their public WiFi networks. Technology companies including Amazon (AMZN), Apple (AAPL), Google (GOOG) (GOOGL), and Microsoft (MSFT) are also indirect players in the space and natural partners for emerging cell carriers, as we'll discuss in greater detail below.
We continue to believe that macro cell towers provide the most economical mix of network coverage and capacity, and the long-term challenges with satellite-based technology 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.
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 with minimal ongoing cap-ex required relative to other REIT sectors. 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.
Investors seeking to capture the 5G themes through real estate can do so through the Benchmark Data & Infrastructure Real Estate ETF (SRVR), which owns a blend of cell tower REITs, data center REITs, and billboard REITs, which often host cellular equipment. Investors seeking more broad-based exposure to 5G as a theme can do so through the Defiance Next Gen Connectivity ETF (FIVG), which has roughly 3% exposure to cell tower REITs, investing primarily in the technology companies providing the equipment and cellular carriers that are expected to deliver 5G services.
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. Cell tower REITs have been among the best-performing real estate sector over the past half-decade. Since NAREIT began tracking the sector in 2012 (which NAREIT labels the "Infrastructure" sector), cell tower REITs have outperformed the REIT index in every year besides 2014.
After a hot start to 2019, however, the high-flying cell tower REIT sector has cooled over the last quarter as investors seek certainty regarding the timing of network deployment post-merger. The Hoya Capital Cell Tower REIT Index remains higher by 31% this year, outpacing the 22% gains from the broad-based REIT index, but is off by roughly 12% from recent record-highs set in September.
The "space race" has also heated-up with SpaceX launching 60 Starlink satellites that it hopes will eventually compete for broadband customers, although we see low-orbit satellites as more likely to be compliments (backhaul) than competitors (end-use consumer devices) to macro-based cellular networks. Also pressuring valuations is Crown Castle's disclosure that the SEC is looking into the firm's capitalization and expense policies. Analysts speculate that the inquiry is based on the firm's practice of expensing rather than capitalizing certain servicing work on their properties. We view this inquiry as fairly benign, but the firm may have to restate recent earnings results. CCI has been the weakest-performer of the group this year, while SBAC has delivered the strongest performance.
Cell Tower REITs have been among the best-performing sectors over the past four years, powered by the network densification required by the later-stages of 4G LTE and the early stages of the 5G rollout. Beneath the noise of the merger frenzy, cell tower REITs delivered another strong third quarter with all three REITs boosting organic growth estimates for full-year 2019. While American Tower continues to deal with the overhang from India's carrier consolidation, posting -20% growth in that region, the company expects this market (15% of NOI) to be a significant growth driver going forward.
The domestic market remains as strong as ever with US revenues rising more than 10% year-over-year, driving a real-estate-sector-leading 10% AFFO per share growth rate. Crown Castle provided an early look at 2020 guidance, forecasting an acceleration in US organic growth from 5.6% in 2019 to 5.8% next year, a pleasant surprise given the commentary that hinted at a possible lull in network investment activity, particularly from T-Mobile and Sprint, amid the merger uncertainty which we'll discuss in more detail below.
All three cell tower REITs beat AFFO estimates in 3Q and SBAC raised 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 of increased network spending.
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 by the fact that these REITs already own 50-80% of all cell tower sites, are easily accretive to earnings. While M&A activity has been fairly muted over the last year, we expect to see these firms continue to grow externally through the combination of acquisitions and internal development, potentially adding a few hundred basis points per year to total return.
Done deal, or so it seems. The mega-merger between T-Mobile and Sprint got the greenlight from the FCC and DOJ and faces one final showdown with 15 state AGs with a trial set to begin on December 9. The emergence of a fourth competitor as a precondition to approval has been an unexpected coup for cell tower REITs.
Questions remain about DISH’s viability as a national competitor, and we expect the focus of the December trial to be on just how serious DISH really is about building out a national network that can compete with the new "Big 3." 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 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 build-out 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.
As we discussed in our last update, there was much debate over the long-term competitive dynamics under different merger scenarios, 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 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 contingent on additional concessions from the "Big 3" to give greater assurance that DISH can indeed become a fourth competitor. DISH, which has acquired rights to 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.
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
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 likely unable to fulfill its 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 With Additional Concessions
To get final approval from the state AGs, T-Mobile and Sprint agree 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 REIT investors are cheering for, we think DISH could find 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 and 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 assets of Sprint. The carrier industry becomes a de facto duopoly and the cell tower REIT's 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 additional concessions are awarded to DISH as a precondition to approval.
As we continue to discuss, 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?
We believe that macro cell towers will continue to be the "hub" of wireless networks for the foreseeable future and we remain confident in the long-term growth trajectory of the cell tower REIT business. Consumers want both speed and mobility at an economic price point and we see macro towers providing the most economic mix of these features. While the tenant base is highly concentrated (and perhaps becoming even more concentrated depending on the outcome of the merger), the tower ownership business is even more concentrated, giving these REITs continued pricing power. Below, we outline the five reasons that investors are bullish on cell tower REITs.
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, satellite networks, 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. Below, we outline five reasons that investors are bearish on cell tower REITs.
Strong performance over the past four years has pushed cell tower REIT valuations towards the more expensive end of the real estate sector, but the roughly 12-14% pullback from record highs may be seen by investors as a long-awaited buying opportunity. Cell towers trade at a 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" capital to fuel external growth.
While they are one of the fastest-growing real estate sectors, cell towers REITs are among the lowest-yielding sectors. Cell tower REITs pay an average dividend yield of 2.2%, well below the REIT sector average of roughly 3.5%. Cell Tower REITs retain roughly half of their free cash flow, leaving ample free cash flow for external growth and eventual dividend growth.
Within the sector, only Crown Castle acts like a typical REIT when it comes to distributions. CCI pays a healthy 3.7% dividend yield, paying out roughly 80% of its available cash flow. American Tower, meanwhile, pays a relatively low 1.7% yield while SBA Communications pays a yield of 0.7%, each retaining the majority of their cash flow.
Done deal, or so it seems. The mega-merger between T-Mobile and Sprint got the greenlight from the FCC and DOJ and faces one final showdown with a dozen state AGs. The emergence of a fourth competitor as a precondition to approval has been an unexpected coup for cell tower REITs. Questions remain about DISH’s viability as a national competitor. 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.
After a hot start to 2019, the high-flying cell tower REIT sector has cooled over the last quarter as investors seek certainty regarding the timing of network deployment post-merger. The space race has heated up as well. SpaceX launched 60 Starlink satellites that it hopes will eventually compete for broadband customers. We view low-orbit satellites as more compliments than competitors, but some investors and analysts may be discounting cell towers REITs as a result of perceived long-term competition.
Fundamentally, cell tower REITs delivered another strong quarter in 3Q19 and continue to deliver sector-leading AFFO growth at nearly 10%. We believe that macro cell towers will continue to be the "hub" of wireless networks and "dealers" of the impending 5G arms race for the foreseeable future and we remain confident in the long-term growth trajectory of the cell tower REIT business. Consumers want both speed and mobility at an economic price point and we see macro towers providing the most economic mix of these features.
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