2 Investments To 'Load Up' Before The Recovery

Summary

• After the recent market rally, investors must become more selective.
• There still exists some great opportunities among smaller and lesser-known REITs, particularly in the net lease and residential sectors.
• We present two of our Top Picks: Spirit Realty Capital and Independence Realty Trust.
• Looking for a portfolio of ideas like this one? Members of High Yield Landlord get exclusive access to our model portfolio. Get started today »

Despite the recent rally, there still exists some generational buying opportunities among smaller and lesser known REITs. Companies that generally trade at 3-4% dividends yields are now offered at 6-8% yields, and offer 50-100% upside potential before they reach their former highs.

We believe that this is particularly true for net lease and apartment REITs because they are well positioned for a rapid recovery:

Net lease REITs own service-oriented properties with >10-year leases. Some rent payments are missing right now, but as we reopen the economy, rent payments will resume and most will remain at a pre-crisis level even if we go into a prolonged recession. The average rent coverage was around 2.5x for net lease REITs prior to the crisis, and therefore, even if profitability drops somewhat, they will still enjoy healthy profits in the aftermath.

Apartment REITs have dropped a lot, but their fundamentals have held up very well. Rent collection remains at 95%-100% and shelter is essential. It's not in the interest of the tenant to stop rent payments, which would only ruin their credit and result in an eviction a few months from now. Even assuming a moderate increase in vacancy and rent delinquencies, the bulk of the cash flow should remain stable.

Below we discuss two undervalued REITs, one net lease and one apartment REIT, that we are buying in anticipation of a future recovery:

Spirit Realty Capital (SRC)

SRC is our largest net lease REIT investment. It owns a diverse portfolio of freestanding single tenant retail properties such as Starbucks (SBUX) coffee shops:

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We see SRC as a deeply-discounted version of Realty Income (O). Both companies are very similar in all aspects, but there's a sizable valuation gap:

Spirit Realty Capital (NYSE:SRC)	Realty Income (NYSE:O)
11x FFO	16.5x FFO
25% discount to NAV	20% premium to NAV
7%	4.5%

Click to enlarge

Granted, O has slightly better assets, a higher credit rating, and a longer track record. However, the differences here are fairly small and certainly do not justify such a massive valuation gap.

We think that O is slightly undervalued, which makes SRC deeply undervalued. There are actually a few things about SRC that even prefer as compared to O:

• SRC has a lower pre-crisis payout ratio at 78% as compared to 83%.
• SRC has longer leases at 10.6 years compared to 9.2 years.
• SRC is 4x smaller which allows it to be more selective and grow faster.

Both are high-quality net lease REITs, but SRC pays a much greater yield, has better long-term growth prospects, and better margin of safety.

SRC recently updated investors that it got ~70% of April/May rents and that the remaining ~30% will be paid back within 12 months. This is not a very big deal for a BBB-rated company with plenty of liquidity.

SRC is our second largest position right now and we expect to keep buying more shares as long as it remains below $45. Please note that we recently wrote a detailed investment report on the entire Net Lease sector at High Yield Landlord.

Independence Realty Trust (IRT):

IRT is our largest residential REIT investment and it specializes in Class B apartment communities:

source

Class B apartment communities are resilient during times of economic distress. They enjoy strong rent-to-income ratios, they are affordable to the masses and there are not many cheaper alternatives. Coming out of the 2008-2009 financial crisis, apartment REITs recovered very strongly:

source

We like IRT in particular because it focuses on the sun-belt markets which enjoy faster growth and a business friendly climate. Right now, numerous activist groups are calling for rent strikes, and we expect IRT to be less exposed to this risk.

Similar to SRC and O, IRT is a discounted version of Mid-America Apartment (MAA). MAA is very similar, but it's larger in size, has a stronger balance sheet, and a better reputation.

Otherwise, their fundamentals and growth prospects are not materially different. In fact, since going public, IRT has performed very similarly to MAA, but with slightly higher returns up until the recent market crash:

Despite being very similar, there exists a sizable valuation gap that reminds us of SRC and O.

Independence Realty Trust (NYSE:IRT)	Mid-America Apartment (NYSE:MAA)
15x FFO	20x FFO
15% discount to NAV	2% discount to NAV
4.5%	3.3%

Click to enlarge

IRT has a higher yield, but also a lower payout ratio at just 58%. It trades at a much greater discount to NAV and each dollar invested earns ~30% more cash flow.

As we discuss in a recent report on IRT, we like its growth prospects and the management is well-aligned with shareholders.

Bottom Line

At High Yield Landlord, we are loading up on Net Lease and Residential REITs which remain greatly discounted even after the recent rally. Combined together, these two sectors represent ~40% of our Core Portfolio:

Source: High Yield Landlord Core Portfolio

The last time REITs were so cheap, it was in the aftermath of the great financial crisis, and it only took them two years to triple in the recovery:

By positioning our portfolio in the most beaten-down REITs with the fastest recovery potential, we expect 50%-100% upside in many of our holdings in the coming years.

It may sound "too good to be true," but it's exactly what has happened following most bear markets and we don't expect this time to be different.

Will prices go lower before they recover?

We don’t know. But what we do know is that prices are exceptionally cheap right now and we are confident that a few years from now, we will look back and be glad that we were greedy when others were fearful.

Analyst’s Disclosure: I am/we are long IRT, SRC, O. 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.