- Roughly two months ago, we were sitting at all-time highs.
- And today we've rallied back significantly, with the broad markets sitting less than 10% off of their prior highs.
- As conservative investors, we do our best to avoid speculation.
- Yet as the market pushes higher and higher in the face of what appear to be ever-deteriorating fundamentals, our concern continues to mount.
- Looking for a portfolio of ideas like this one? Members of iREIT on Alpha get exclusive access to our model portfolio. Get started today »
This article was co-produced with Nicholas Ward.
In July 2019, I wrote an article on Seeking Alpha titled, "The Dangers Of High Yields: Something Wicked This Way Comes," which was somewhat of a harbinger for the high-yield investors that can become hypnotized by the glare of fool's gold.
Most recognize that title from the association with Ray Bradbury's book, Something Wicked This Way Comes, is one in which the author "describes a night like no one else... somewhere in him, a shadow turned mournfully over. You had to run with a night like this so the sadness could not hurt."
Before you pounce on me for suggesting that COVID-19 is not a "black swan" because I predicted it, stop right there.
While my article did suggest pain was lurking in the stock market, I never predicted that the REIT sector would lose $250 billion in value in less than 60 days. Instead my pitch was something like this,
"I'm becoming increasingly concerned that many writers and investors are ignoring the potential for a principal erosion. This low-yield environment we're in has resulted in folks carelessly ignoring fundamentals, hoping to achieve instant gratification as they do. Yet instant gratification is rarely worth it in the end."
Needless to say, something wicked is now here and investors should be even more cautious when it comes to chasing high-yield stocks. We are 100% quality-focused and we believe that our strategy will pay off in the long-run.
Investing For The Long Run
What crazy times we live in. Roughly two months ago, we were sitting at all-time highs. Roughly one month ago, the stock market was down at multi-year lows, having fallen more than 30% from all-time highs. And today, we've rallied back significantly, with the broad markets sitting less than 10% off of their prior highs.
While we're not seeing 10%+ swings on a daily basis with regard to the major averages nowadays, this volatility is still historically unique. We’re still living in unprecedented circumstances with wide swaths of the economy in the U.S. and abroad turned off by the social distancing measures put into place because of COVID-19.
We've received positive news in recent days regarding potential therapeutics that may be effective in treating the disease. There are plans to begin phasing out social distancing practices being put into place across the country as Americans attempt to return to normal. But, as we've said many times in recent weeks, we're not so certain that this will ever happen.
No one knows what the "new normal" will look like in a post-COVID-19 world, but we suspect that the populous will be living different lives than the ones they were experiencing just a couple of months ago for the foreseeable future.
Because of this, we continue to believe that there is a lack of clarity moving forward with regard to the sales and profits likely to be generated by the companies that we cover. And, without this sort of insight into the future, we have to admit that investors buying into this rally are doing so on the basis of speculation.
As conservative investors, we do our best to avoid speculation. Investing in equities always comes with a certain degree of risk. No one knows what the future holds, which is why even the bluest of the blue chips in the equity space are still considered to be risk assets.
We manage this risk by analyzing the fundamentals of the companies in our portfolios and attempting to determine fair value estimates and margin of safety. Without a clear picture of the fundamentals in the short term it becomes more and more difficult (if not impossible) to do these things.
Even listening to many of the CEO interviews that we've performed recently, subscribers have heard many of the upper level management figures that we've spoken to acknowledge the uncertainties that they face.
This is why we've moved so many of our ratings to speculative buys or even outright sells at iREIT. This is also why we've become so apprehensive of high, potentially unsustainable yields. It's why we've dialed in our focus on the absolute strongest companies with the best balance sheets, physical assets, lowest risk industry exposure, and historical track record of success during turbulent times.
Yet, as the market pushes higher and higher in the face of what appear to be ever-deteriorating fundamentals, our concern continues to mount. And, with this being said, we've grown wary of the idea of putting a lot of new capital to work in today's market because of the apparent downside risk.
But, this cautious stance doesn't mean that it's time to go on vacation. Beaches are beginning to open up in certain areas of the country, but instead of packing up our swim trunks and our sunscreen, we're working in maintaining our watch lists with a sharp focus on the recent weakness, apparent support levels, and yield thresholds that we find attractive.
In recent weeks, some absolutely fantastic buying opportunities have arisen in the REIT space. Unfortunately, the recent rally has caused many of them to diminish, or outright disappear. However, that doesn't mean they won't return. And, if they do return, it will likely be during a bout of fear-inducing, market-wide, negative volatility.
During times like that, it generally proves difficult to act rationally unless you've prepared ahead of time. This preparation is what we want to talk about in this piece, specifically with regard to three names that we've covered recently and wanted to provide an update on due to the recent market volatility.
Realty Income (O)
When thinking about high-quality REITs with reliable dividends, I think most investors' minds go to Realty Income first. This company is well known for its monthly dividend. Realty Income has now made 597 consecutive monthly dividend payments.
And, during our recent interview with Realty Income CEO, Sumit Roy, the dividend was referred to as "sacrosanct," implying that management would do whatever it could throughout the current uncertain COVID-period to protect it. For years, O has traded with a premium valuation. Investors very rarely have an opportunity to buy shares of "The Monthly Dividend Company" at historically low valuations. Well, just a couple of weeks ago was one of those times.
As you can see on the F.A.S.T. Graph above, shares of Realty Income dipped below their long-term P/FFO average briefly during the depths of the COVID-19 sell-off. Recent news regarding the reopening of retail in certain areas of the country has sparked a rally in the triple-net space and O is now, once again, trading right at that long-term average.
Source: F.A.S.T. Graphs
Today's valuation on O shares is still significantly cheaper valuations than what we've seen for much of the last decade or so. We continue to believe that O is a bargain. However, we understand conservative investors wanting to lock in wider margins of safety in today's market due to the relatively high degree of uncertainty ahead with regard to likely FFO in 2020 and even 2021.
With that in mind, we think it's worth mentioning that O shares recently hit lows of $38.00/share, which is approximately 27% lower than today's current share price in the $52 area. While we don't necessarily think it's a good idea to wait for prices that low, the fact that the market went there does prove that even the most darling of stocks like Realty Income include downside risk in a market environment like this one.
Oftentimes, we talk about short-term share price movement being unpredictable. Obviously this has been the case in the short term. However, disregarding the recent COVID-19 volatility that started in late February, if you take a look at the F.A.S.T. Graph above, you will see that the black line, which represents share price, has been quite jagged for some time now.
However, the white line, which represents dividends, has been steady and much more reliable. Assuming you agree with us that O's dividend is safe, we think it makes more sense during volatile times like these to focus on the dividend and take solace in the predictable nature of that white line.
With this in mind, focusing on attractive yield thresholds can make sense for income-oriented investors when thinking about the risk/reward and margin of safety when putting capital to work.
Today, O shares yield roughly 5.1%. We suspect that many investors have used this ~5% yield threshold as a target (and we don't blame them). But, what if you wanted a bit more bang for your buck with regard to dividend yield?
Well, with O's current $2.80 annual dividend, shares would yield 6% at $46.70. This price target is roughly 9.8% below today's share price.
O's dividend will touch the 6.5% yield threshold at $43.10. This price target is roughly 16.8% below today's share price.
The 7% yield threshold will be hit at the $40/share level. $40 is roughly 22.8% below today's share price.
For income-oriented investors who might be wary of the current market rally that we've experienced, we think that using price targets like these will not only help to eliminate fearful emotions during a bear market and result in better sleep at night.
W.P. Carey (WPC)
WPC is another REIT in the triple-net space that we're bullish on. We recently covered WPC in a focus ticker article, highlighting our belief that the company's well-diversified portfolio and high-quality tenant base results in a high degree of dividend safety.
At today's valuation, we continue to believe that WPC shares are priced fairly. However, like O, WPC shares have experienced a strong rally in recent weeks and we wanted to take a look at potential price points based upon the underlying fundamentals and dividend yield thresholds that conservative investors may find intriguing.
Source: F.A.S.T. Graphs
As you can see on the graphic above, excluding massive, relatively unexplained intra-day drop down to its new 52-week low of $38.62 (we say unexplained because when WPC fell more than 25% that day, there was no major news regarding the company and when we reached out to management, they attributed it to abnormal market volatility), WPC shares found support right at their long-term average.
It's funny how that works out, isn't it? This just goes to show the importance of fundamentals in the grand scheme of things.
We would like to note that while WPC's long-term average P/FFO ratio is fairly low, in the 12.75x area, more recently, WPC shares have seen multiple expansion because of corporate restructuring and management's new focus on the triple-net revenues as opposed to the managed investment funds. Simply put, the market sees the triple-net sales are more reliable and higher quality and therefore, it is willing to place a higher premium on them.
In the past, WPC's valuation has lagged behind its other well-known peers in the triple-net space. As you saw above, Realty Income's long-term average P/FFO multiple is 16.27.
National Retail Properties (NNN) is another dividend aristocrat that many income-oriented REIT investors love to own and its long-term average P/FFO multiple is 15.27. As you can see, a hierarchy has formed over the years, with O at the top and WPC at the bottom when talking about triple-net names that have long annual dividend increase streaks.
Yet, when WPC made the move to focus on net-lease income with the CPA-17 merger in late 2018, we believed that it would begin to close that valuation gap. It turns out we were right, which is why WPC has been a top performer in recent years. Yet, the COVID-19 sell-off essentially canceled out all of the gains that the company's shares have made with regard to multiple expansion and now investors have the opportunity to buy back down at the pre-CPA-17 merger levels.
Source: F.A.S.T. Graphs
Throughout this piece, we've highlighted our belief that FFO figures in the short term are incredibly hard to predict at this point and with that in mind, we'd like to again focus on some yield thresholds that income-oriented investors may find attractive.
WPC's relatively low multiple has historically meant that WPC shares have carried higher yields than its triple net peers. This remains the case. Today, WPC yields 6.32%, which we find attractive alongside near-record low yields.
However, this 6.32% yield pales in comparison to the stock's recent high-yield market that was north of 10% at its 52-week lows. While we don't expect to see WPC trade down to the $40 mark in the short term, we understand that investors looking for wider margins of safety or better risk/reward with regard to yield on cost might want to wait for weakness to push the yield higher.
WPC shares will yield 7% at $59.40/share. For shares to hit this yield threshold, they will have to fall roughly 4.9% from today's share price in the $62.50 range.
For WPC share to hit the 8% yield threshold, they will have to fall approximately 16.6% to $52.00/share.
WPC will hit the 8.5% yield threshold, they would have to trade for $48.90. They would have to sell-off 21.7%.
Digital Realty (DLR)
Because of their exposure to areas of the economy that have been shut down by social distancing measures, both O and WPC shares remain fairly, if not attractively, priced in today's market. However, the third stock that we'll be doing a recap on today is not.
DLR is, without a doubt, an incredibly high-quality company. It's a best-in-breed player in the data-center sector that appears to be one of the most resilient in all of REITdom. In recent months, we've highlighted DLR as a top pick several times for subscribers and we've certainly been pleased with the stock's performance.
Due to its reliable FFO outlook, investors have flocked into DLR. Yields across even the highest-quality REITs have come into question due to fears surrounding rent collection, but these fears haven't extended to DLR. And because of this, DLR trades with the highest valuation premium that we've seen on shares in over a decade.
We've really focused on quality as of late at iREIT due to the concerns created by the COVID-19 crisis; however, that doesn't mean that we're abandoning our value investing principles.
Because of its high quality, we're not recommending that investors sell their DLR shares. This has become a defensive holding within the REIT space and so long as its dividend remains safe and continues to grow, we're generally happy to maintain long-term outlooks on blue chip stocks. But, we're also not looking to buy into this decade-plus high multiple, either.
Because of the more reliable nature of DLR's FFO in this environment, we're able to focus more on P/FFO multiples when arriving at price targets for DLR than yield thresholds.
Source: F.A.S.T. Graphs
Today, DLR trades for roughly 22.2x ttm FFO. On a forward-looking basis, DLR is trading for 22.9x 2020 FFO consensus estimates and 21.45x 2021 consensus FFO estimates. All three of these figures are incredibly high relative to DLR's long-term P/FFO average multiple of 16.1x.
When thinking about buying DLR, we acknowledge the stock's reliable FFO and therefore, dividend yield, and agree with the market that this is a stock that deserves a premium. Yet, we're not looking to pay a price that is ~37.5% above its long-term premium. Instead, we're placing DLR's fair value in the $115 range, which implies a 17-18x premium, or roughly 10% above the long-term average.
Throughout this piece, we've also focused on yield thresholds for income-oriented investors who're wary of EPS/FFO estimates in today's market and would rather focus on the income they expect to receive. With regard to DLR, our fair value estimate closely corresponds with the 4% yield threshold.
At $112/share, DLR would touch that 4% mark, and at that point in time, we would find DLR shares to be very attractive. Unfortunately, that also means that they'd have to fall some 23% from current levels. We're certainly not willing to hold our breath as we wait for that sort of sell-off to occur. But, it is worth mentioning that during the worst days of March, DLR shares did fall down to 52-week lows $105.00, so the $112 target is not entirely out of the question.
Author's note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.
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This article was written by
Brad Thomas is the CEO of Wide Moat Research ("WMR"), a subscription-based publisher of financial information, serving over 175,000 investors around the world. WMR has a team of experienced multi-disciplined analysts covering all dividend categories, including REITs, MLPs, BDCs, and traditional C-Corps.
Thomas has also been featured in Barron's, Forbes Magazine, Kiplinger’s, US News & World Report, Money, NPR, Institutional Investor, GlobeStreet, CNN, Newsmax, and Fox.
He is the #1 contributing analyst on Seeking Alpha in 2014, 2015, 2016, 2017, 2018, 2019, 2020, 2021, 2022 and 2023 (based on page views) and has over 111,000 followers (on Seeking Alpha). Thomas is also the author of The Intelligent REIT Investor Guide (Wiley) and is writing a new book, REITs For Dummies (Wiley/Amazon).Thomas received a Bachelor of Science degree in Business/Economics from Presbyterian College, and he is married with 5 wonderful kids. He has over 30 years of real estate investing experience and is one of the most prolific writers on Seeking Alpha. To learn more about Brad visit HERE.
Analyst’s Disclosure: I am/we are long O, DLR, 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.
Nicholas Ward owns shares in O, WPC, and DLR.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.