A Worrisome Market: 2 Top Buys For Yield

Summary

• The spooky market may have you scared.
• We’ve spotted some buy ratings in this worrisome environment.
• Investors should be looking for lower-risk securities.
• Looking for a portfolio of ideas like this one? Members of The REIT Forum get exclusive access to our model portfolio. Get started today »

This research report was produced by The REIT Forum with assistance from Big Dog Investments.

The market has become scary.

Opportunities seem to be drying up.

Au contraire, the opportunities are everywhere if you take a moment to look.

We will go over 2 buy ratings today and an investment we decided to cut back on significantly.

Triple net lease REIT

STORE Capital (STOR) gets a buy rating. Yeah, STOR! You may remember STOR from prior months where we considered it a great company at a terrible price. Falling from $40 to $32.86 creates a much more attractive price.

Source: The REIT Forum

For what it’s worth, we would still be bearish on STOR if shares were trading near $40.00. STOR benefits from great management, a reasonable balance sheet, extremely long leases (great during recession fear), and a knack for accretive growth. An era of low-interest rates would be ideal for triple net lease REITs. The risk rating of 2 is as high as we expect to go on any new positions in equity REITs right now.

STOR benefits from a unique strategy for direct origination:

Source: STOR

They were able to achieve an efficient scale on a “direct origination” platform.

What does that mean? The platform enables them to buy properties directly from small owners. They require additional details on the business so they can ensure that the properties they own are critical to the tenant. The tenant can still agree because STOR can access the capital markets at a dramatically lower cost than the tenant. The result is arbitrage. The tenant unlocks cash that was tied up in their portfolio, but the cost of rent is easier than bearing debt.

They issued shares at a low price, once. Precisely once. They did it when the market was in a panic and they issued the shares directly to Berkshire Hathaway:

Source: STOR

Why did they do that? Because it put them in a position to say:

“Warren Buffett owns our shares. Why don’t you?”

Remember that triple net lease REITs look to grow by issuing shares above net asset value. STOR knows precisely how to run that technique. They issued a small volume of shares at a cheap price to bring Buffet in. Then they ran the share price dramatically higher. It was a one-time cost with a permanent benefit.

We like STOR here because they have a great triple-net portfolio for a recession:

Source: STOR

We see several advantages for STOR if a recession starts, but a key element is a long duration of leases. Since STOR has been growing rapidly, they’ve acquired many of their properties within the last few years. That leads to most leases being new, which means they will have more years left. STOR drives this point home:

We will note that STOR’s success is partially driven by acquiring properties at higher cap rates:

Source: STOR

Notice how STOR has an exceptionally high circle in the bottom square? That demonstrates the combination of cap rate plus rent bumps. How is STOR able to get those high cap rates on acquisitions? A key part is their origination platform helping them to source deals. However, we have to assume that the average portfolio quality isn’t going to be as high as it will be for Realty Income (O). That’s something to keep in mind, but it doesn’t prevent STOR from being a great REIT.

As you may recall, for long-term picks we have a preference for REITs with superior corporate governance:

Source: STOR

Much like our expectations for Americold (COLD), we’ve seen STOR delivering growth:

Source: TIKR.com

STOR is driving results through their system of acquisitions:

Source: STOR

Excellent technique by STOR to demonstrate how they are generating excess value for shareholders. They also started with a low dividend rate so they could deliver outsized growth in the first several years and establish themselves as a dividend grower:

Source: STOR

If a textbook were written on how to launch a triple net lease REIT, the textbook would be named after STOR.

Triple net lease REITs have two key factors for investors to remember.

1. They put a huge emphasis on trading over NAV and issuing shares to drive growth.
2. Most of FFO reaches AFFO because recurring capital expenditures are low.

Let’s look at the translation from FFO to AFFO:

Source: REITbase.com

The line for recurring capital expenditures is running $0 for STOR. That’s not going to be a realistic assumption when leases start expiring, but we would expect it to remain extremely low. That allows most of FFO to reach AFFO, which means there's more cash to either pay dividends or reinvest in the portfolio. A wise triple net lease REIT wants to retain some cash flow because they want to ensure they won’t be pressured too hard during a recession. Growing dividends throughout a recession is important to establishing a premium brand, which is necessary to trade above NAV and fund growth through issuing shares.

Are there any changes we’d like to see at STOR? We could go for slightly lower leverage. Even with the triple net lease REITs, we still love to see leverage low.

Technicals

We need to bring investors back to the technical factors for a moment. It’s not the main part of our analysis, but we should at least reference it. The technicals look horrendous. Each of our recent equity REIT picks appears to be falling off a cliff. That's by design. These are each picks where we want to own the company, but wanted to see a more attractive valuation.

If you look at the technicals for PS Business Parks (PSB), consider the technicals for their peers. Even though PSB has the best balance sheet among all industrial REITs, they suffered far worse than peers over the last three months. The technicals for the rest of the sector aren’t nearly as scary. There isn’t a viable reason for PSB to continue falling, while peers, which own similar portfolios but have more leverage, would outperform. To be transparent, we’re including the price charts:

Source: Seeking Alpha

Source: Seeking Alpha

Source: Seeking Alpha

That beating on STOR looks pretty scary. However, we want to highlight the movements throughout the sector using our $100k chart. Remember, the $100k chart shows how much an investor needed to invest on any given day to have $100k today (dividends reinvested). The chart for triple net lease REITs is shown below:

Source: The REIT Forum

We love using the $100k chart in our triple net lease REIT picks. It was a critical part of the timing for our Dec. 18, 2019, buy alert on W.P. Carey (WPC). The fall in EPR Properties (EPR) made it look attractive, but we spent about five days digging into it and determined EPR was too risky for our subscribers.

Source: Seeking Alpha

That helped investors avoid one of the worst performers in the sector. If it seems like we should’ve warned investors about STOR being overvalued instead, we did.

In our December 2019 triple net lease REIT sector update for subscribers we highlighted STOR and Spirit Realty (SRC) as being too expensive.

Source: The REIT Forum

CMO-E

CMO-E (CMO.PE) took a dip recently (shares are still in our buy range as of 3/6/2020) and gave us an opportunity to acquire some shares. We placed the order after the price dropped. Shares came down to $25.40, which brought them into the target buying range:

Source: The REIT Forum

The main risk factor for shares of CMO-E is the call risk. At $25.40, our worst-cash-to-call was a loss of $.05. We can live with that risk. Shares have been quite steady, as shown in the chart below:

Source: StreetSmart Edge

The weekly price movements over the last five years show how rare it has been for CMO-E to get pummeled. That’s great for us. It's a reflection of the relatively low risk in these shares.

Our Order

We picked up these shares in the Fidelity account since they don’t have a floating rate. Consequently, Fidelity still allows investors to place orders online under the ticker CMOPRE:

Source: Fidelity

You can see we had only partial execution. We set a limit-buy for 1,000 shares, but only acquired 329.

Anworth Mortgage

We STILL own 6,000 shares of Anworth Mortgage (ANH), which represents about 4.7% of our total portfolio.

We reduced our allocation because ANH was more than 10% of our portfolio. We were willing to take on that much risk heading into the earnings release, but don’t want to keep such a large exposure open.

Recent trades are shown below:

Source: Fidelity

Source: Schwab

Source: Schwab

The final results on the closed positions are shown below:

We still have a material allocation to ANH as shown by our open positions:

ANH still represents 4.69% of our portfolio. That feels more appropriate given the change in the market environment. While mortgage REITs were beaten down fiercely over the last week, many (including ANH) rallied substantially today. ANH recovered more than 5% so far on the day. On the other hand, Treasury yields continued to plunge.

That pushes up prepayment expectations and pushes down book value. Neither is favorable.

Source: MBSLive

The only positive note is that the yield curve is steepening some, which should help to partially offset the other issues. With mortgage REITs potentially entering a downward trend, further book value losses already occurring, and a handful of the mortgage REITs still in the overvalued range, we decided to reduce exposure to the sector. We still consider AG Mortgage Investment Trust (MITT) and ANH more attractive than their peers by a material margin, but we’re taking the opportunity to reduce risk.

Final Thoughts

Today's market leaves investors needing to be careful. However, there are plenty of buying opportunities for the investor who's willing to look. We recommend that investors looking to buy should be looking at lower-risk companies and preferred shares. Preferred shares offer investors a high yield with relatively low risk. Common stocks can be a great buy, but we are mostly sticking with strong balance sheets.

Ratings: Bullish on STOR and Bullish on CMO-E.

Analyst’s Disclosure: I am/we are long ANH, CMO-E, COLD, PSB, STOR, WPC. 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.