Seeking Alpha

Our 2020 High Yield REIT Portfolio

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Includes: AI, CBL, CXW, GMRE, GNL, IRM, IYR, MAC, MGP, MPW, OUT, PEI, STAG, UNIT, VICI, WPG
by: Dane Bowler
Dane Bowler
Value, hedge fund analyst, REITs, long/short equity
Summary

Our portfolio yields 8.01% with a clean payout ratio of 69%.

Strong cash flows are the key to sustainable oversized yields.

We scour the REIT universe to handpick what we believe are the stocks best positioned to outperform.

This article was selected to be shared with Seeking Alpha PRO+ Income subscribers - find out more here.

It seems an increasing portion of investors is realizing the benefits of a growing stream of dividend income. It is the ultimate way to have your money work for you and provides a great set up for financial success. In this low-interest rate environment, attaining said stream of dividends can be rather challenging and the methods of pursuit that have worked in the past are no longer available.

Coming out of the recession, investors had great success buying the beaten up names with outrageously high yields. They got both price recovery and outsized dividends. At the same time, high quality stocks were deeply discounted and dividend investors could buy up these companies at a reasonable price and ride the organic dividend growth.

These strategies have worked for the better part of the last decade but times have changed and more importantly, valuations have changed.

Source: multpl.com

The companies that have grown their dividends consistently are now trading at sky-high multiples which presents a real risk of losing principal from valuations returning to earth. Yield chasing looks equally problematic today as many of the companies trading at large yields have fundamental problems or are simply not earning the dividends they payout which leads to principal erosion.

Going forward, it will be significantly more difficult to attain a strong and growing yield at a portfolio level. Growing one's investment income stream will not be as simple as buying stocks with a certain history of dividend growth or above a certain yield: It will require a more nuanced approach.

Total return focused dividend growth

Rather than pursuing dividend income directly, I prefer to think of it as more of an interconnected system in which all roads lead to Rome. Trading and capital gains are often considered at odds with dividend growth investing, but they all lead to the same place. Capital gains mean you have more money to invest in dividend-paying stocks which means more dividend income. If we maximize our total returns today, we can generate more dividend income tomorrow.

Thus, our high yield portfolio has a dual mandate: maximizing total return and growing dividend income. We do not believe that one can be effectively pursued without the other. 2CHYP, our high yield REIT portfolio, is now 3 and a half years into its mission to generate a growing stream of dividends.

So far, the dividend stream has grown nicely with indicated dividends of $10,176 (as of 12/31/19) which represents a yield on invested capital ($100,000 seed money) of 10.17%. However, we recognize that the investment environment has gotten more challenging and we will have to be clever to keep it growing going forward. As of 12/31/19, the portfolio looked like this:

Relative positioning

There are roughly 180 publicly traded equity REITs in 20 different property sectors. We have selected the above REITs for their mix of value, growth, dividends, and diversification. Collectively, these REITs have some key advantages over the REIT index.

The REITs in 2CHYP trade at a weighted average discount to NAV of about 7.5%. We like to buy at discounts to private market value because getting more valuable properties for each dollar invested results in greater cash flows. The opportunistic valuation of these REITs means the portfolio generates an 11.4% FFO yield compared to just 4.5% for the REIT index. The greater cash flow of these REITs allows them to payout a collective 8.01% dividend while having plenty of cash left over for investment in properties with a 69.12% payout ratio.

In contrast, the REIT index is overvalued at the moment, causing its relatively lower cash flows to only sustain a 3.65% dividend yield with a higher payout ratio of 80.56%.

Higher cash flows are the key to dividend growth. They simultaneously facilitate higher current yield and organic cash flow growth through reinvestment in properties.

Retail: CBL.PE, MAC, WPG, PEI collective weight: 13.58%

We are underweight retail compared to the REIT index, but our holdings are shifted away from shopping centers and toward malls.

In the long run, we believe e-commerce will affect shopping centers and malls in roughly equal proportion, but the market seems to think shopping centers are fine while malls are doomed. Thus, the shopping center REITs trade at fair value while the malls are extremely discounted. While it is true that mall tenants have made up the majority of bankruptcies and store closures, it has little to do with e-commerce. Quite simply, the big box retailers were overlevered and had antiquated business models.

The disappearance of retailers like Sears was overdue and will be healthy for the tenant mix of malls. 2019 featured a wave of store closures and the market has extrapolated that wave as an annual run rate. We see it more as a one-time event. Retail has always had cycles and this one is no different. The weak retailers die and new ones come in to replace them. It causes some disruption but the landlords survive. This cycle may have been a bit more challenged than those of the past due to being simultaneous to e-commerce disruption, but it will pass. We see 3 key reasons malls will persist.

  1. Gen Z loves malls. As a generation that grew up with the internet, they are painfully aware of the mental health implications of sitting in front of a screen all day cooped up in the house. They have learned to counteract this accidental agoraphobia by actively seeking reasons to get out of the house and malls are ideal real-world interactions. Delivery has been available for much of their lives, but they choose to buy in store and their purchasing power will increase sharply as they reach peak earning ages.
  2. Sales per foot are rising and occupancy costs are low. Tenants can now have space in malls at an incredibly low cost relative to sales which will increase demand and facilitate occupancy re-uptake
  3. Some of the weaker malls have died off already and there has been negative overall supply. This rebalances the supply and demand dynamic in favor of landlords. We see a significant recovery in leasing rates.

I believe a diversified basket of mall REITs is positioned to outperform. Why have we chosen these particular mall REITs?

Macerich (MAC) sits at the high end of the quality spectrum. It has trophy properties with an average sales per foot above $700. Throughout the retail apocalypse, they have grown sales per foot and same-store NOI has been stable. The greater than 60% drop in market price has not been matched by fundamentals, leaving the shares deeply below intrinsic value.

Pennsylvania REIT (PEI) is a reformed B mall REIT that is now on the brink of becoming an A mall REIT. It recognized the need to change far earlier than its peers and is therefore further along in the transition. In fact, the upswing of the transition is upon us. Fashion District Philadelphia has recently opened to great success and a few more redevelopments are slated to open in the near term. Collectively, these are anticipated to drive a turnaround in which both same-store NOI and FFO/share grow in 2020. At a dirt cheap multiple of 4.3X, PEI is not priced for growth.

Washington Prime (WPG) is perhaps a more controversial stock as its growth projections are less concrete. However, WPG has been doing some truly innovative things at the operational level that we believe will cause it to outperform. WPG regularly hosts experiential events in its malls that drive traffic from a larger catchment radius. This brings in shoppers that would not normally be spending dollars at these locations. WPG has also done a better job than its peers of fixing its tenant mix. They monetarily incentivize their leasing agents to bring in internet resistant retailers and have a greater diversity of tenants. While WPG's sales per foot is still in the B mall range, their properties have a superior vibrancy that will bring in new tenants at higher rents.

CBL Properties Preferred E (NYSE:CBL.PE) represents a broad market misunderstanding of the way preferreds work. Distressed debt markets are generally somewhat efficient with discounts to par that are proportional to the actual risk. Preferred markets do not have the same institutional capital or research and are often wildly inefficient. The market is pricing CBL common and CBL debt as if CBL has a decent chance to turn things around. I agree with the market's assessment here. The preferred, however, is priced for about a 20% chance that CBL survives. It is simply mispriced relative to the rest of their public capital stack. We think CBL will come out the other side of the challenging environment significantly diminished from when they went in, but mere survival represents a greater than 400% return for those who get into CBL.PE at these prices.

An often forgotten characteristic of preferreds is that they have a par value that does not fluctuate with company fundamentals. CBL is undoubtedly weaker than it was, but CBL.PE still has a par value of $25 per share. Importantly, while the preferred dividends are suspended, they accrue and must be paid before the common can pay a dividend. As a REIT, CBL will eventually have to pay a common dividend if it survives. REITs are required to pay out at least 90% of taxable income as dividends to common. CBL can pull some tricks such as taking impairment charges to keep taxable income at $0 for 2020, but in 2021 and beyond it will be increasingly hard to avoid paying a dividend assuming the company survived. When they do pay the dividend, they legally must pay all accrued preferred dividends. At current pricing, CBL.PE's dividend is accruing at a rate of 35% a year. I am happy to wait as long as it takes.

It is a risky position, and our small weight in the stock reflects this, but the weighted average outcome looks firmly positive.

Healthcare: MPW and GMRE collective weight 17.56%

For quite some time, our thesis on healthcare REITs has been that hospitals and medical offices were the superior property types.

  • Senior housing has terrible oversupply issues
  • Skilled nursing has insufficient reimbursement resulting in razor thin margins

In contrast, hospitals require a certificate of need to be developed which goes a long way to preventing oversupply. Medical office is benefiting from the trend toward outpatient care.

Despite the superior fundamental positioning, MPW and GMRE had consistently traded at sizable discounts to other healthcare REITs. Even after the substantial price gains of recent years, MPW and GMRE remain among the better values in the healthcare REIT space.

Medical Properties Trust (MPW) has grown its FFO/share at an impressive pace which has matched the price gains, thereby keeping its multiple down. Its growth comes from an impressive spread between its roughly 5% cost of capital and its 8%+ cap rate acquisitions. MPW is the leading real estate owner of hospitals in the U.S. and it is gaining substantial presence in the U.K. and mainland Europe. Its operators are healthier than the operators of other healthcare REITs with a substantially higher EBITDAR coverage of rent.

Global Medical REIT (GMRE) has similar growth prospects to MPW in that its spread between cost of capital and acquisition cap rates is significant. With medical office, there exists a gap in cap rate in which one-off properties trade at a 100+ basis point higher cap rate than portfolios of medical office of equal quality. GMRE arbitrages this difference by doing the work of buying large numbers of one-off properties and assembling them into a portfolio.

Pure Yield Plays - GNL, AI.PC and MGP collective weight: 20.32%

Given where treasury yields are, most stocks with a clean dividend have been bid up to the point where the yield is tiny. Occasionally, however, some stocks fall through the cracks and we believe that is the case with these REITs. Given the reliability of their cash flows, they should be trading at significantly lower yields.

Global Net Lease (GNL) has been a long term holding for us as the market has consistently undervalued it based on a perceived dividend cut risk. Frankly, GNL is not quite earning its dividend, but the market is valuing the stock with fear, rather than valuing based on what the dividend should be. A $1.60 dividend would be very well covered and a triple net REIT with a $1.60 dividend would trade far more expensively than GNL's market price of $20.28 (as of 12/31).

GNL's cash flows are among the most reliable as it has long contracts, most of which are between 6 and 12 years remaining duration. These contracts are with strong tenants as GNL has I believe the highest percent of their tenants' investment grade of any triple net REIT.

The only real complaint about GNL is that their payout is too high, but I want to point out how irrelevant this is. Whether GNL pays an unsustainable $2.13 annually or a sustainable $1.60 annually, the accretion to shareholders is based on the earnings and GNL's earnings are rock solid. Value this company based on its earnings, not on its dividend policy. If they want to pay me more than they should I'll find a use for the cash. If they want to right size the dividend, that is fine too. Either way its clean contractual income.

Arlington Preferred C (NYSE:AI.PC), much like CBL.PE, represents a broad misunderstanding of how REIT preferreds work. REIT preferreds are too often traded like equity where the prices bounce around when a company has a good or bad quarter, but in financial math, they are closer to debt that is simply below the debt in the waterfall.

Arlington is an agency mREIT which means its fundamental value is quite mathematically calculable since its assets are backed by the U.S. government. As long as book value remains above $0, the preferred is worth $25 a share and it is hard to imagine the book value dropping to $0 given that the assets are insured by the government. Earnings and book value will fluctuate with interest rates and the shape of the yield curve, but they fluctuate within a fairly fixed range and the low end of that range is well above a $0 book value.

MGM Growth Properties (MGP) is thought of as a casino REIT which is viewed as risky, but we see it as more of a triple net REIT. Its contract length is longer than that of most of the triple nets meaning its cash flows are both visible and contractual in nature for the next decade. The security of the cash flows is increased by the strong EBITDAR coverage of its primary tenant. We formerly owned Vici Properties (VICI) in 2CHYP, but swapped into MGP instead as MGP's tenant is more profitable.

MGP has a strong history of both FFO/share and dividend growth and its massive acquisition pipeline provides an opportunity to keep growing.

Data - IRM and UNIT collective weight: 15.57%

There are many different REITs with which to invest in the exponential growth of data. Data centers are essential for the processing of the data. Towers are integral to the wireless transmission of data to end users and fiberoptics are the basis of long distance data flows.

Data is a hot area and in many cases the multiples of the associated stocks reflect the heat. As a value investor, I am attracted to the stocks that have access to the powerful demand drivers but are trading at deep discounts.

Iron Mountain (IRM) is by far the most value-oriented data center REIT. Some view its legacy storage and security business to be in decline, but I think the market is underestimating the longevity of the need for physical documents. When people think about physical document storage they associate it with paper files and they rightfully conclude that much of that is moving to digital storage, but there are other kinds of files that remain excellent candidates for IRM's legacy business.

  1. Files that are intentionally redundant. Important documents are often stored both physically and digitally. Servers can crash and files of a certain nature must be able to be accessed. For example, IRM has a contract to store police camera footage.
  2. Files that are too sensitive to be on the cloud where hacking is a possibility. IRM has a stellar record of protecting its files.
  3. Physical objects: IRM has a growing business of storing and protecting fine art.

Overall, IRM's physical storage business has continued to grow and its growth has been supplemented with a transition into data centers. IRM is quickly becoming a data center REIT, already acquiring billions of dollars' worth of data centers. With its size and experience, IRM has access to the same demand drivers that fuel the other data center REITs. It just doesn't come with the pricey multiple.

Uniti Group (UNIT) is a fiber REIT with over 6 million strand miles of fiber. This makes UNIT one of the largest fiber owners in the U.S. and fiber is a rapidly growing business. 4G macro cell towers depend on fiber and 5G small cells also depend on fiber for backhaul. As communication infrastructure rolls out, demand for fiber will increase and I think the overlooked opportunity is the margin with which UNIT can take on new customers. UNIT's fiber is only about 30% utilized at the moment and that extra capacity can be leased up with almost no incremental cost. Additional tenants represent extremely high margin revenue growth.

The market is not examining UNIT's growth potential because it is caught up in the Windstream drama. This is discussed at length elsewhere, and the associated challenges are more than priced into the stock.

Industrial - STAG 4.87% weight

We are substantially underweight industrial relative to the index, largely because we view the sector as overvalued. Over the past few years, industrial REITs have been taking advantage of the demand boom from e-commerce and increasing rental rates rapidly. Many of the industrial REITs have been rolling expiring rents up by 15% to 30%. That is a phenomenal growth rate and we like the fundamentals of the sector. The problem is that the market is projecting this growth rate to continue for another decade and the stocks are priced for perfection.

It is already to the point where coastal industrial facilities are charging rents more typical of office. This cannot go on indefinitely. Companies are not going to pay $30-$50 a foot annual rent for a warehouse. There are natural limits to how high rents can go. We are bearish on the coastal REITs as their growth is approaching the limit while their multiples require them to continue growing rapidly.

STAG Industrial (STAG) is the outlier. While its market price has done well, it still remains a good value at a discount to the broader REIT index multiple. Its facilities are located primarily in tier 2 locations such as highways on the outskirts of cities. We view this as a great location and going forward I think it will be superior to the tier one last mile locations. It is simply more economical to store goods and perform logistics in these areas where property values are less extreme.

STAG has a nice acquisition pipeline that they execute with a level of discipline not seen in other industrial REITs. Ben Butcher and the rest of the STAG team have developed a rigorous analytical framework for acquisitions that results in being picky about what they buy. STAG rejects a majority of the properties it looks at, only buying the ones it sees as opportunistic. That is how we buy stocks and we love to see that same approach applied to properties

Corrections - CXW 10.72% weight

CoreCivic (CXW) is the heaviest single stock weight in the portfolio because it represents the greatest mismatch between fundamentals and valuation. It trades at 6.5X FFO which is normally a multiple reserved for REITs with negative growth, but it is growing at a rapid pace.

Source: CXW filings

Those 20% growth numbers would be impressive for a high multiple REIT and usually don't exist in a REIT trading at 6.5X.

Demand for detention facilities is up substantially from ICE, U.S. Marshalls, and individual states. There are few sources of supply for these facilities as the government does not have the will to put up a massive up front cost to build facilities of its own. The facilities that are owned by the government are getting outdated, causing them to be more expensive to run and less safe. This is causing an increasing portion of detainees to be routed to private prisons and CXW is getting many new contracts. These contracts are growing revenues and FFO at an impressive pace and there are more in the pipeline with CoreCivic winning development projects with states.

So why does CXW trade so cheaply?

Politics.

In the past, the use of private prisons has not fallen on clear party lines with both Democrats and Republicans supporting or opposing the industry to varying degrees. Today, however, it is more partisan, with the progressive left strongly opposing the industry. Both Bernie Sanders and Elizabeth Warren have stated plans to abolish the industry.

We think this is unlikely to happen, even if one of these candidates wins in 2020. Financially, there are few alternatives and it would be inhumane to suddenly move all detainees from private prisons to public ones that are already overcrowded.

The rhetoric against the industry is rampant, but when it comes down to the mechanics of actually changing things, the willpower will die down.

CoreCivic is priced at about half of where it would be without political risk. The risk is real, but a 50% discount seems quite extreme given the chance of the risk actually manifesting.

Advertising OUT 4.96% weight

The weights in this article are as of 12/31/19. We have since sold OUT for valuation reasons, but I will discuss the stock anyway as it is likely something we will own again in the future.

Outfront Media (OUT) is the leader in the transition to digital advertising on physical displays. At the moment, digital display boards aren't all that much more profitable than traditional billboards, but there is real potential here. Digital displays can be changed in a moment rather than having to repaint the billboard. This means advertisers could buy slots by the hour instead of by the month. McDonald's could advertise from 4:00 to 6:00 on weekdays as people are on their way home from work. Special events could advertise heavily in the week before the event.

This level of targeted advertising has the potential for substantially higher revenues per duration and OUT is the closest to realizing it.

Manufactured Housing - UMH 10.31% weight

Manufactured housing is the best solution to Americas housing affordability crisis. Manufactured homes are substantially cheaper than traditional construction while still providing residents with secure communities and the pride of being a homeowner.

This is structurally a great industry as demand is high and supply is limited by strict permitting. All of the REITs in the space have had great success raising rents and occupancy. UMH has been raising rents a bit faster than peers and we see this continuing. Its rustbelt focused location is ideal since manufactured housing is affordable for a blue collar workforce.

We see UMH as being economically cyclical. As long as the macroeconomy holds up, growth should continue.

Performance

We think about performance along two lines:

  1. Total return
  2. Dividend growth

So far, 2CHYP has made some progress on each metric. Since inception on 7/1/16, it has returned 29.74% which compares just slightly favorably to our benchmark, the iShares U.S. Real Estate ETF (IYR).

In the long run, total return is the most important metric, but over the short term, it can be a bit misleading as it is heavily influenced by price fluctuations.

Tracking dividend growth along with portfolio cash flows helps to ensure that the progress is real and fundamental in nature rather than the stocks just getting more expensive. 2CHYP's dividend income has grown to $10,176 annually which represents a 10.17% yield on initially invested capital.

Goals and risks

Going forward, our goal is to continue to grow both total returns and the dividend stream. We believe the mix of holdings in 2CHYP sets us up to achieve both goals. We will undoubtedly be wrong on some of our picks which is why we have structured the portfolio to have broad diversification between economic sectors. Further, we believe the majority of the risks we are taking are idiosyncratic in nature such that problems in one stock should be uncorrelated with the others. CXW's political risk is entirely unrelated to mall risks or to UNIT's Windstream risk. These stocks are individually volatile, but when combined the idiosyncrasy of their risks should statistically be a calming factor. This allows us to capture the greater expected return associated with "risky" stocks without having to suffer the same magnitude of risk at a portfolio level.

We have done quarterly updates on this portfolio for years and will continue to make these publicly available. A quarter is a long time, and much can change in the interim. Members of our marketplace, Retirement Income Solutions, get continuous access with real time trade alerts, analytics and earnings updates. We provide the tools to help members generate growing streams of income.

Important Notes and Disclaimer

The holdings presented were the entire holdings of 2CHYP as of 12/31/19, but may not represent the holdings for other time periods. We do not intend presentation of 2CHYP's holdings as a recommendation, but rather as a statement of historical fact.

We cannot determine whether the portfolio holdings presented are suitable for any given reader. Readers are encouraged to contact their financial professional to discuss the suitability of any strategies or holdings prior to implementation in their portfolio.

The specific securities identified and described herein do not represent all of the securities purchased or sold for advisory clients of 2nd Market Capital Advisory Corporation (2MCAC). It should not be assumed that investments in the securities identified and described were or will be profitable.

A list of all prior purchases and sales made by the investment advisor representative (Dane Bowler) in the 2CHYP portfolio is available upon request. It should not be assumed that purchases and sales made in the future will be profitable or will equal the performance of the securities in this list.

Benchmark Comparison: 2CHYP portfolio is compared to the iShares U.S. REIT ETF it is a common method for investing in a portfolio of REITs and we view it as competitor or alternative to 2CHYP. IYR has fees that are factored into performance, while 2CHYP does not have a fee aside from trading commissions which are factored into performance. 2CHYP's dividends are reinvested, while IYR's dividends are paid but not reinvested.

Strategy and market conditions: 2CHYP uses a bottom up stock selection process which may fare better in certain market conditions than in others. It may perform better when value is in favor or worse when value is out of favor.

Expenses: Returns reflect the deduction of any transaction expenses. There are no costs or management fees charged nor deducted.

Past performance does not guarantee future results. Investing in publicly held securities is speculative and involves risk, including the possible loss of principal. Historical returns should not be used as the primary basis for investment decisions. Although the statements of fact and data in this article have been obtained from sources believed to be reliable, 2MCAC does not guarantee their accuracy and assumes no liability or responsibility for any omissions/errors.

Calculation Methodology: Partial year return for the period 7/1/16 through 12/31/19, unaudited. Dividends in 2CHYP are reinvested.

Conflicts of Interest. We routinely own and trade the same securities purchased or sold for advisory clients of 2MCAC. This circumstance is communicated to clients on an ongoing basis. As fiduciaries, we prioritize our clients' interests above those of our corporate and personal accounts to avoid conflict and adverse selection in trading these commonly held interests.

2nd Market Capital and its affiliated accounts are long STAG, WPG, MAC, CBL.PE, PEI, UNIT, UMH, IRM, GNL, GMRE, MPW, OUT, AI.PC, MGP and CXW. I am personally long STAG, WPG, MAC, CBL.PE, PEI, UNIT, UMH, IRM, GNL, GMRE, MPW, OUT, AI.PC, MGP and CXW. This article is provided for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer. Information contained in this article is impersonal and not tailored to the investment needs of any particular person. It does not constitute a recommendation that any particular security or strategy is suitable for a specific person. Investing in publicly held securities is speculative and involves risk, including the possible loss of principal. The reader must determine whether any investment is suitable and accepts responsibility for their investment decisions. Dane Bowler is an investment advisor representative of 2MCAC, a Wisconsin registered investment advisor. Commentary may contain forward-looking statements that are by definition uncertain. Actual results may differ materially from our forecasts or estimations, and 2MCAC and its affiliates cannot be held liable for the use of and reliance upon the opinions, estimates, forecasts, and findings in this article. Positive comments made by others should not be construed as an endorsement of the writer's abilities as an investment advisor representative.

Disclosure: I am/we are long STAG, WPG, MAC, CBL.PE, PEI, UNIT, UMH, IRM, GNL, GMRE, MPW, OUT, AI.PC, MGP, CXW. 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.