Earlier this month, we published an update on our recent performance and explained that our portfolio has now fully recovered and continues its multi-year streak of significant outperformance:
However, because of this recovery, it's now getting harder to find discounted REITs in today's market.
To be clear, it does not mean that it is too late to invest in REITs.
Quite the opposite: We currently have 26 Strong Buy-rated REITs and an additional 20 Buy-rated REITs in our Portfolio Sheets at High Yield Landlord.
What it means is simply that most REITs are now fairly valued and investors need to become more selective to identify the last remaining bargains.
Therefore, we are slowly shifting from a phase of aggressive accumulation to a phase of more selective accumulation and portfolio recycling to make sure that our capital is invested in the most optimal way possible.
This implies that we will likely sell one or a few holdings that trade at close to fair value and use the proceeds to double-down on other existing positions and/or invest in new opportunities.
Below we highlight two existing positions that we expect to increase over the coming weeks. These REITs remain deeply undervalued and are set to soar in the coming years.
iStar (STAR)
STAR is a mortgage REIT with a diversified portfolio of loans, net lease properties, ground leases, and other land investments. It's a complex portfolio that is difficult to value, and for a long time, the lack of specialization has caused STAR to fly under the radar.
But recently, the story has become cleaner as STAR rebranded itself as a pioneer of ground lease investing.
It launched a separate REIT called Safehold (SAFE), which it manages against fees and also owns 2/3 of its equity. (If you are not familiar with ground leases and the background to STAR/SAFE, please click here to read our full investment thesis.)
This caught our attention in early August when we noticed that its stake in SAFE alone was worth nearly twice the current share price of STAR, and that's without giving any value to STAR's other properties.
In the end, we concluded that STAR was undervalued by a factor of ~3 and bought shares in the company. Since then, the investment has been quite successful. STAR is up by 49% compared to just 10% for the average of the REIT sector during this time period:
Data by YChartsBut as surprising as it may sound, STAR is today just as undervalued despite the surge in its share price.
This is because, over the same time period, its stake in SAFE has gained over 50% in value:
Data by YChartsToday, SAFE's market cap is $3.65 billion, STAR's market cap is $1.2 billion, and STAR owns 2/3 of SAFE - worth ~$2.3 billion. As such, its stake in SAFE is now worth nearly 2x more than its own market cap.
So, in short, the opportunity in STAR remains just as good as it was in August, despite having risen by nearly 50%. In an efficient marketplace, STAR would have needed to rise by more than that to keep up with its subsidiary, SAFE.
Why is SAFE doing so well?
Its ground lease concept is gaining market acceptance, property owners need to find alternative capital sources, and investors need safe income in a yieldless world. As a result, it has been able to grow at a phenomenal rate:
The size of its portfolio has grown 10x since its IPO in 2017:
As SAFE continues to grow like a weed, we expect STAR's market perception to soon change from "complex mortgage REIT" to "ground lease pioneer" and with that, its valuation will also expand closer to fair value.
STAR is likely worth a multiple of its current share price already today, and its underlying value is growing at a rapid pace. While you wait for upside, you get paid a relatively small ~3% dividend yield, but it is growing at a rapid pace (10% dividend growth in 2020).
We maintain our Strong Buy rating and expect to buy more of it in the near term.
Crown Castle International
Recently, many growth REITs experienced significant volatility as a result of the rising treasury rates.
Among those, Crown Castle International (CCI) is arguably the best opportunity. It recently dropped by 15%, despite posting strong results, and this pull-back is our long-awaited buying opportunity:
Warren Buffett has famously said that most often, investors would be better off buying "wonderful businesses at fair prices" rather than "fair businesses at wonderful prices." This is because time is on the side of wonderful businesses which continue to grow in value over time.
Crown Castle is the perfect example of a "wonderful business at a fair price" in the REIT market.
It's not enormously discounted, but after the recent drop, its valuation is reasonable, and most importantly, its long-term prospects are very attractive.
Crown Castle is one of the three major cell tower REITs, which are positioned to gain from the rollout and maturing of 5G networks the next decade:
- It's a recession and COVID resistant business.
- It has a strong growth tailwind.
- It's expected to grow the dividend at 7-8% per year in the long run.
- It has guided for 10% AFFO per share growth in 2021.
- And the current dividend yield is 3.6%.
As such, Crown Castle can realistically deliver 12-15% annual returns from a lower-risk business.
It has massively outperformed the broader REIT market (VNQ) since it was created and it appears likely to deliver superior risk-adjusted returns for many years to come:
Therefore, it's an easy pick for our Retirement Portfolio. It will likely contribute alpha, all while boosting our average dividend growth rate, and providing valuable diversification benefits.
The timing today is particularly attractive because it is the first time in over a year that it is trading at below $150. It dropped by 15% even as it guided for 10% AFFO per share growth in 2021, which is superior to its growth rate over the past few years.
Why CCI Instead of AMT or SBAC?
We are bullish on all three cell tower REITs at today's prices: Crown Castle, American Tower (AMT), and SBA Communications (SBAC).
However, there are two main reasons why we favor Crown Castle for our Retirement Portfolio:
Reason #1 - Aligns Better With Our Objective: The main goal of our Retirement Portfolio is to maximize safe income over time. Crown Castle yields today 3.6%, which is materially more than AMT's 2.4% and SBA's 0.97%, and its focus is clearly on rapidly growing this dividend. The first slide of their investor presentation makes it clear: they target 7%-8% annual dividend growth, which is precisely what we want.
Reason #2 - Small Cell Upside Potential: Crown Castle invests heavily in small cells whereas AMT and SBAC have elected to focus instead on their tower business. We believe that Crown Castle's focus on small cells makes the long-term risk-to-reward even more compelling because as 5G densities approach 7 nodes per square mile, it provides the potential "to meaningfully increase long-term shareholder value creation beyond the value created by the current 7-8% annual dividend growth target."
When you take this into account, the management estimates that the potential upside is 4x by 2030. But even if it never comes to fruition, CCI is well positioned to deliver solid returns to shareholders.
Bottom Line
We experienced a strong recovery over the past months and our Portfolio is now hitting new all-time highs.
Even then, there are still some attractive opportunities if you know where to look.
STAR and CCI are two great examples of that.
In total, we currently invest in ~30 similar opportunities at High Yield Landlord.
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