2 'Untouchable' REITs To Power Your Retirement Portfolio

Summary

• Picture the strong castle and the wide moat and people sitting inside peering out at the sharks circling in the water.
• Of all of the tools available to these “lords in the castle” what is the most important weapon that can help defend against enemy threats?
• A "fortress" balance sheet!
• This idea was discussed in more depth with members of my private investing community, iREIT on Alpha. Learn More »

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Warren Buffett once said, “a good business is like a strong castle with a deep moat around it. I want sharks in the moat. I want it untouchable.“

Can you imagine this right now?

A strong castle surrounded by a deep moat with sharks in it?

What a perfect analogy to describe the perfect stock to own, in which the company’s competitive advantages are described as “moats” that include cost of capital, economies of scale, innovation, intellectual property, network effect, and switching barriers.

But what’s critical for investors to recognize is that the strength of the castle is directly correlated to the size of the moat. Buffett also said,

“We are trying to figure out what is keeping — why is that castle still standing? And what’s going to keep it standing or cause it not to be standing five, 10, 20 years from now. What are the key factors? And how permanent are they? How much do they depend on the genius of the lord in the castle?”

Now picture the strong castle and the wide moat and people sitting inside peering out at the sharks circling in the water. Of all of the tools available to these “lords in the castle” what is the most important weapon that can help defend against enemy threats?

A "fortress" balance sheet!

What do I mean by “fortress”? Duff McDonald provides this answer in Last Man Standing: The Ascent of Jamie Dimon and JPMorgan Chase, according to McDonald, “Dimon always embraced the importance of a "fortress" balance sheet, as he explained,

"…it consisted of ample 'high-quality' capital paired with a strong liquidity position that would protect the firm from the assault of an economic downturn, which also provided the ability to launch an attack on weakened competitors."

Warren Buffett added,

"If you are evaluating a business year-to-year, the number one question you want to ask yourself is - could the competitive advantage have been made stronger and more durable before — and that’s more important than the P&L for a given year."

And Buffett’s mentor and friend, Benjamin Graham explained,

“…the defensive investor must confine himself to the shares of important companies with a long record of profitable operations and in strong financial condition”.

Within our coverage spectrum (at iREIT on Alpha), there are 9 A-rated REITs (there were 10 until Boston Properties (BXP) was downgraded to BBB+). The combined market capitalization of this A-rated REIT universe is just over $300 billion (as viewed below):

Source: iREIT on Alpha

As you can see, some of the dominant A-rated REITs include:

• Prologis (PLD) with a market cap of $94.5 billion
• Public Storage (PSA) with a market cap of $52.1 billion
• Simon Property Group (SPG) with a market cap of $43.8 billion

Needless to say, these constituents are top 10 holdings of the Vanguard Real Estate ETF (VNQ) since the strategy is to market cap weight the largest names.

Source

In addition, there are other strong-rated high-quality REITs within VNQ’s top 10 list such as American Tower (AMT) – rated BBB- by S&P, Crown Castle (CCI) rated BBB- by S&P, Equinix (EQIX) – rated BBB by S&P, Digital Realty (DLR) – rated BBB b7 S&P, and Welltower Inc. (WELL) – rated BBB+ by S&P.

However today we’re mining for “gold” that is, the highest A-rated REITs that can be purchased with a wide margin of safety.

As viewed below, iREIT on Alpha has screened the A-rated REIT universe to carefully select the top companies to buy right now. As usual, we always screen for quality and value using our iREIT on Alpha tracking tool:

Source: iREIT on Alpha

As you can see, the cheapest REITs to buy, based on current P/FFO compared with the 5-year P/FFO average include:

• Simon Property (SPG): 19% discount to 5-year P/FFO
• Realty Income (O): 2% discount to 5-year P/FFO

And several of the most expensive include:

• Camden Property (CPT): 51% premium to 5-year P/FFO
• Prologis Inc. (PLD): +41% premium to 5-year P/FFO
• AvalonBay (AVB): +29% premium to 5-year P/FFO
• Equity Residential (EQR): +26% premium to 5-year P/FFO

Source: iREIT on Alpha

It’s interesting to see that SPG has returned 61% YTD, while O has returned 9% YTD. This offers valuable clues as we consider these 2 A-rated REITs in greater detail.

O, O, O, It’s Magic

Realty Income is the only A-rated Net Lease REIT, and this is one of the company’s primary competitive advantages. The company is rated A3 by Moody’s and A- by S&P and because of the fortress balance sheet Realty Income has access to a low-cost, diversified capital pool.

Because of Realty Income’s conservative capital structure, the company is able to achieve best-in-class credit metrics such as:

• 5.4x Net Debt to EBITDAre
• 6.0x Fixed Charge Coverage Ratio
• 27% Debt to Total Market Cap
• 97% Unsecured debt
• 86% Fixed Rate debt
• 8.5 years W.A. term to maturity for notes & bonds

Realty Income also has ample liquidity and low Borrowing costs that support enhanced financial flexibility. This includes foreign debt such as the recent (July 2021) debt green bond, a £750 million multi-tranche denominated unsecured bond offering of 6 years and 12-year notes, priced at a combined all-in rate of 1.48% and a weighted average term of approximately 8.8 years.

Again, this is a competitive advantage in which Realty Income is able to improve both its scale and cost of capital by investing dollars in Europe. There’s limited retail supply and supply growth in the U.K. and this supports the company’s long-term viability of stable cash flow generation.

The recently announced Vereit (VER) deal is expected to be 10%+ accretive relative to the midpoint of 2021 AFFO per share guidance and refinancing opportunities will allow Realty Income to generate organic growth for years in the future. Superior credit ratings and access to international capital markets are catalysts for value creation.

One other thing worth noting, I looked at PLD when the company obtained its A-rating on December 2016 and I compared it with Realty Income when it obtained the A-rating on August 2018.

Source: Yahoo Finance

I know it's “apples and oranges” but consider the fact that PLD is +178% since its S&P upgrade and Realty Income is up just +7.5% during the same time frame. Clearly Mr. Market does not know that Realty has an impressive “fortress” balance sheet, but this chart clearly identifies the disconnect.

Realty Income has a sizeable moat, superior to the direct peers, and we consider the latest pullback an opportunity to own more shares. Given the recognizable catalyst with Vereit and the continued discipline of the organization we are affirming our Buy thesis with expected annual returns of 15%.

Source: FAST Graphs

Simon Says, Buy!

Similar to Realty Income, the net lease consolidator, Simon Property Group is the consolidator in the mall REIT sector. The company owns an interest in 203 income-producing properties in the U.S., which consists of 99 malls, 69 premium outlets, 14 Mills, 4 lifestyle centers and 17 other retail properties in 37 states and Puerto Rico.

Simon also owns an 80% non-controlling interest in The Taubman Realty Group – which has an interest in 24 regional, super-regional, and outlet malls in the U.S. and Asia.

You may recall that last year Simon was successful in shaving $1 Billion off the purchase price of Taubman, a "not too shabby" ROI and "savings" that represents ~one-turn of debt/ebitda.

Internationally, Simon has ownership interests in 31 premium outlets and designer outlet properties primarily located in Asia, Europe and Canada. Then there’s its 22.4% equity stake in Klépierre SA (OTCPK:KLPEF), a publicly-traded, Paris-based real estate company that owns or has an interest in shopping centers throughout 15 countries in Europe.

(Incidentally, I’m headed to Paris this weekend and I plan to meet with the management team while I’m there.)

Simon has significant embedded value in its existing real estate portfolio, and this will be a source of growth. Since 2012, it’s invested more than $8 billion to enhance its retail offerings and add complementary mixed-use components to its best-in-class properties.

Simon’s balance sheet continues to differentiate it from its peers, given its strong investment-grade credit ratings of A/A3 and access to capital. At the end of Q2-21, it had liquidity of more than $8.8 billion, consisting of $6.9 billion available on its credit facility and $1.9 billion of cash.

SPG paid $1.40 per share of dividend in cash (on July 23), which was a 7.7% increase year-over-year. The Q3-21 dividend is $1.50 per share, which is an increase of 7.1% sequentially and 15.4% year-over-year (payable on Sept. 30).

SPG increased its full-year 2021 FFO guidance range from $9.70-$9.80 per share to $10.70-$10.80. That’s a $1 increase at the midpoint and that represents approximately 17%-19% growth compared to 2020 results.

Analysts are forecasting SPG to grow FFO per share by 19% in 2021. Shares are now trading at $133.71 with a dividend yield of 4.5%. We target them to return another 20% over the next 12 months.

Source: FAST Graphs

Untouchable = Quality

In my new book, The Intelligent REIT Investor Guide, I explain that

“The most conservative investors – those seeking quality and safety above all else – are prone to buying blue-chip REITs. Regardless of whether that describes you personally, it’s vital for all REIT investors to know what makes these investments stand out. They’re the ones that set the standards all others REITs are measured by, including the alternative choices detailed below.”

In addition to owning blue chip REITs I also explain that “smart and capable management is what separates mere collections of properties from superior real estate-oriented businesses” and “the true test of quality comes when the going gets rough.”

Most all REITs have now been “pandemic tested” and as I conclude,

“They’re also in better positions to take advantage of opportunities to pick up sound, well-located properties at bargain prices – that can then be put back on track to produce excellent returns for shareholders.”

Net Lease REITs: Debt/Total Market Cap

Source: REIT Base

Mall REITs: Debt/Total Market Cap

Source: REIT Base

Net Lease REITs: Payout Ratio (based on AFFO)

Source: REIT Base

Mall REITs: Payout Ratio (based on AFFO)

Source: REIT Base

Source

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.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of AMT, AVB, BXP, CCI, DLR, O, SPG either through stock ownership, options, or other derivatives. 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.