Market Carnage Creates Opportunities In REITs

Summary

• In the market sell-off, some stocks fell more than others.
• Specifically, the triple nets fell an unusual amount.
• Given their resilience to pandemics relative to other stocks, we believe the sizable drop represents a great entry point.
• This idea was discussed in more depth with members of my private investing community, Retirement Income Solutions. Get started today »

Last week, markets sold down dramatically on the threat of a pandemic. The selling was broad based but not evenly distributed which left some stocks significantly oversold. Further, the areas that sold off were not necessarily fundamentally exposed. Let us begin with a quick review of where the selling occurred.

REITs dropped about 12% from the peak just over a week ago.

Source: SNL Financial

Let us examine the breakdown by property type. There was some semblance of rationality at the property sector level as the magnitude of selling corresponds to the potential for fundamental harm.

Source: SNL Financial

Hotels are arguably the most susceptible. Even if COVID-19 does not become widespread in the U.S., the restrictions on international travel will prevent tourists from coming in, so I suspect hotel bookings will be weak in Q1 and Q2 even in the best-case scenario.

Manufactured housing, self storage, and residential are entirely domestic and none of them involve congregating in large groups of people. Given this inherent resilience to an outbreak, it makes sense that these sectors would have outperformed.

At an individual company level, however, selling behavior got out of whack. I believe the overreaction was most visible in the triple nets.

Source: SNL Financial

These are fundamentally among the least impacted, yet they sold off substantially more than the index. As you know, triple net revenues are contractual in nature which makes them locked in until lease expiry or tenant default.

Most of the triple net REITs, including the ones charted above, have weighted average remaining lease terms of 5-15 years. This disease scare, even if it becomes a pandemic, will be long over by the time a significant portion of leases rolls. There may be a few quarters of disruption to some of their tenants, but given that their tenants are largely investment grade, I doubt some disruption would cause significant tenant defaults.

Thus, the revenues and FFO of the triple net REITs will only be minimally impacted if at all. The 15% to 25% drop from the peak just over a week ago seems entirely overblown. I chose to focus on Global Net Lease (GNL) Gladstone Commercial (GOOD), American Finance (AFIN), and One Liberty Properties (OLP) because they were already at a decent value price prior to the selloff. Today, they are quite opportunistic.

Triple nets are often thought of as bond substitutes since the contractual nature of their revenues makes their cash flows quite steady. As such, they often trade at a spread to Treasuries. When Treasury yields move up, the triple nets often sell down such that their dividend yields maintain a roughly constant spread.

Well, in this COVID-19 selloff, there was a divergence. The vast flight to safety drove huge amounts of capital into treasuries, causing the 10-year treasury yield to crater to 1.1%.

Source: SNL Financial

This is essentially the lowest treasury yields have been, so according to the bond substitute style of trading, the NNN REITs should also be trading at record low yields. In contrast, the NNN REIT dividend yields have spiked. GNL now has a greater than 10 percentage point spread between its dividend yield and that of the ten-year treasury.

This divergence in which broader interest rates have gone down and the dividend yields of these triple nets rose has made now a great time to buy. We spent much of last week loading up on triple net REITs.

AFIN and GNL recently reported 4th quarter earnings with solid results, but this news got lost in the media hysteria around COVID-19.

From AFIN's 4Q19 report:

Adjusted funds from operations ("AFFO") increased 1.8% year-over-year to $104.9 million, or $0.99 per diluted common share from $103.0 million, or $0.98 per diluted common share, in prior year"

A 1.8% increase year over year in AFFO is exactly what a triple net REIT is supposed to do. Contractual rent escalators pull rental revenues up incrementally each year.

AFIN should be among the most resilient triple nets as it has extremely high quality tenants. Also, from the 4Q19 report:

High quality portfolio of investment grade or implied investment grade rated tenants in 100% of Top 10 tenants portfolio-wide"

Global Net Lease also put up solid results including accretive asset recycling.

From GNL's 4Q19 report:

Strategic European disposition of $146 million at a 6.72% cash capitalization rate generated a $10 million realized gain with all proceeds to be redeployed into Q1 2020 closed and current pipeline acquisitions of $273.7 million at a weighted average cash capitalization rate of 7.10%, providing a 38 basis point arbitrage spread"

These transactions are immediately accretive and allow GNL to reset its lease terms.

We believe the value NNN REITs listed above represent a great mix of fundamental strength and high yield.

Analyst’s Disclosure: I am/we are long OLP, GOOD, AFIN, GNL. 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.

2nd Market Capital and its affiliated accounts are long GOOD, OLP, AFIN and GNL. I am personally long GOOD, OLP, AFIN and GNL. Full Disclosure: All content is published and provided as an information source for investors capable of making their own investment decisions. None of the information offered should be construed to be advice or a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. The information offered is impersonal and not tailored to the investment needs of any specific person. Please see our SA Disclosure Statement for our Full Disclaimer