In a recent article, I explain that REITs are still in the early stages of a multi-year repricing that will push REITs to new historic highs.
Put shortly, there are a lot of investors who absolutely need income, and in a world of near-0% interest rates, bond proxies like REITs have significant upside potential as their yields compress to new all-time lows.
We showed the example of Germany where high-quality properties commonly trade at 2%-3% cap rates because interest rates are so low and investors are desperate for income.
The same is now coming to the US, but we're still in the early stages of the repricing, and that's why we are so bullish on REITs.
We think that REITs that currently offer 4%-6% dividend yields will soon reprice at closer to 2%-3% dividend yields.
Investors who buy today still have the chance to get high yields and position themselves for significant upside as REITs get bid up and yields compress.
But, what are the best REITs to profit from yield compression?
That's what many of you asked me in the comment section of the previous article. Not all REITs are created equal, and some are definitely better positioned than others.
In today's follow-up article, we will discuss our two favorite REIT property sectors to maximize gains in a yield-compressing world and highlight a few individual REIT opportunities that we currently own at High Yield Landlord.
The Best REITs for a Yield-Compressing World
The REIT market is vast and versatile. Some invest in hotels, others in shopping centers, and some even in billboards.
Each property sector has unique investment characteristics that make them more or less desirable in a yield-compressing world.
Historically, those property sectors that generated the most defensive cash flow and steady growth have enjoyed the most cap rate compression. On the other hand, those that generated highly volatile and unpredictable cash flow have not participated as much in the yield compression.
Going forward, we think that two REIT sectors, in particular, are very well positioned for the anticipated yield compression.
These are net lease REITs and healthcare REITs. Combined together, they represent over 40% of our REIT portfolio:
Net lease REITs generally own freestanding, single-tenant retail properties such as Taco Bell (YUM) restaurants and Dollar General (DG) convenience stores:
Healthcare REITs, on the other hand, mostly own medical office buildings, skilled nursing facilities, and hospitals:
It may seem at first as if these REITs have little in common. Yet, in reality, they're very similar because of how they structure their leases.
Net lease and healthcare REITs both commonly use what we call "triple-net" leases, which result in bond-like income with added inflation protection:
- Very Long Lease Terms: The initial term is a minimum of 10 years, but more commonly 15-20 years, and then include several five-year extension options. The lease term is so long because the tenant makes major investments into the property and it is essential to the operation of its business.
- Tenant Pays Expenses: In most cases, the lease stipulates that the tenant is responsible for all property expenses, including even property taxes, insurance, and maintenance. As such, the rent is pure profit and the cash flow is highly predictable.
- Contractual Rent Hikes: The leases typically include ~2% annual rent increases or 10% increases every five years. These increases occur regardless of market conditions because they are contractually agreed upon when signing the lease.
- Low Vacancy Risk: Because the property is essential to the business of the tenant, the vacancy risk is very low. As an example, a well-performing Taco Bell is unlikely to move elsewhere, even if it could lower its rent because it would disrupt its existing customer base and lead to high costs. As long as your tenant can turn a profit in the location, vacancies are highly unlikely.
Because "triple-net-leases" result in bond-like cash flow, they're ideal for a yield-compressing environment.
These REITs are arguably the closest thing to bonds in the entire public equity markets. Many of them keep paying steady dividends even during recessions and generate steady annual growth in the 4%-8% range.
Even then, there are several of these REITs that still trade at 4%-6% dividend yields, and offer significant upside potential as they reprice at closer to 2%-3% yields in the aftermath of this crisis.
Below, we highlight three such REITs that we currently own at High Yield Landlord.
Realty Income (O)
Realty Income is the most famous of all net lease REITs. It's best known as "The Monthly Dividend Company," which is the nickname of the company.
It's called that way because it has a multi-decade track record of providing dependable monthly dividend income with annual raises and no interruptions.
Not even the great financial crisis or the pandemic could stop the dividend hikes. It's quite literally a bond with inflation protection in that sense.
What makes it so resilient?
Realty Income has an A-rated fortress balance sheet and it targets net lease properties that are leased to recession and Amazon-resistant concepts such as grocery stores, convenience stores, gyms, quick-service restaurants, etc.
Below is an example of a Walmart (WMT) owned by Realty Income:
Today, Realty Income is priced at a 4.2% dividend yield, but as we put the crisis behind, I expect it to reprice at a ~3% yield, unlocking ~40% upside to its shareholders.
A 4.2% yield from an A-rated company with steady ~5% annual growth is simply too much and won't last for long in a yieldless world.
Medical Properties Trust (MPW)
Medical Properties Trust is the only REIT that specializes in hospital properties, and just like Realty Income, it uses triple-net leases in order to generate highly dependable and predictable cash flow.
- It has 16 years left on its leases on average.
- Tenants pay all property expenses, including maintenance.
- Rents increase each year by 1-2% with CPI-based rent floors.
That allowed the REIT to keep growing its dividend even through the pandemic. It has now grown its dividend for eight consecutive years with annual hikes in the 4%-6% range.
Currently, the company is offered at a 5% dividend yield, and we expect it to reprice at a 3.5% yield, unlocking 40% upside to investors who buy it today.
W. P. Carey (WPC)
W. P. Carey is another net lease REIT, but unlike most of its peers that target retail-based properties, WPC targets mainly industrial properties.
This approach is potentially even more defensive because, in today's world, Amazon-like companies are growing at a rapid pace and they need a lot of industrial space.
This strategy has allowed WPC to hike its dividend for 20 years-plus in a row, including the great financial crisis and the pandemic:
source
Currently, WPC is priced at a 5.8% dividend yield. We estimate that it should trade at closer to a 4% dividend yield, meaning that it has 45% upside potential as its yield compress in the aftermath of this crisis.
Bottom Line
These REITs are the closest thing to bonds in the public equity market and therefore they have the most upside potential in a yield-compressing environment.
If like me you believe that we will remain in an ultra-low yield world for a long time to come, then buying this type of REITs will likely result in large gains in the coming years.
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