Sell Alert: 2 REITs Getting Risky

Summary

• The Omicron variant has already resulted in new restrictions which will likely hurt a number of REITs.
• This is particularly true for three property sectors: hotels, offices, and malls.
• While we remain bullish on most REITs, we highlight 2 that we would sell because of their poor risk-to-reward ratio going forward.
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In a recent article entitled: "Omicron: Very Bad News For REITs", we explain that the discovery of a hyper-contagious variant could further delay the recovery and cause significant pain to three property sectors in particular.

These are hotels, offices, and malls.

Hotels suffer from the now stricter travel restrictions which reduce international travel. Moreover, the longer the pandemic lasts, the less likely it becomes that business travel ever fully recovers as people get used to holding Zoom (ZM) meetings, and meanwhile Airbnb (ABNB) also keeps gaining market share because it is perceived to be a safer option.

Offices suffer additional delays in the return of workers to the office, which makes a full return less and less likely as employees become accustomed to remote/hybrid work and companies are forced to heavily invest in building their digital infrastructure.

Finally, malls could face declining traffic and sales if stricter mask, social distancing, and maximum capacity mandates are imposed. Those are already being reimposed in many countries and considered in others.

Despite that, many of the REITs that own these properties continue to trade at relatively high valuations as if nothing had changed. They initiated sold-off when the news came out, but then quickly recovered most of the losses in a classic "dead cat bounce" pattern.

If you still own such REITs, now may be a good time to consider selling. Below, we highlight 2 REITs that we would sell because they offer poor risk-to-reward, and finally, we highlight 2 better alternatives for you to consider.

Host Hotels & Resort (HST)

HST is the largest hotel REIT in the world. Since we first highlighted it as a REIT to avoid in the wake of the Omicron variant, it has dropped another 7%, but it still isn't cheap enough for us to entertain a position.

Even after the recent dip, HST is still priced as if the pandemic was pretty much over with its share price lingering right where it was in late 2019:

Data by YCharts

Yet, if you look at its fundamentals, we are still far from pre-covid levels of profitability:

source

Sure, things are a lot better than they used to be in the second quarter of 2020, but the average revenue per room is still 30% lower, and things worsen again in the coming quarters.

We suspect that HST's share price got ahead of itself because the market expected a travel boom in the post-covid world as everyone was eagerly waiting to travel again after close to two years of canceled trips.

That makes sense. However, beyond a short-term spike in travel, I think that the long-term prospects of HST have forever deteriorated as a result of the pandemic, and therefore, it does not deserve to trade at pre-covid levels.

Here, you need to consider that:

• HST owns a lot of hotels that focus on business travel, which will likely never fully recover in the post-covid world. We just don't need to travel for as many meetings anymore. It is a lot more efficient to hold 10 Zoom calls in a day than to travel for just one meeting.

• HST investors also forget that Airbnb has kept gaining a lot of ground over the past year. People view Airbnb as a safer option because you are in close contact with fewer people at the check-in / check-out and all the people who switched to Airbnb during the pandemic will keep using it even after it is over.

• Finally, HST also owns a lot of hotels that focus on international travel, which will now take even longer to recover, if it ever does. The US has now reopened borders to most foreigners, but it has imposed stricter testing requirements, which makes traveling more complicated, and other foreign countries are also putting additional restrictions to discourage international travel. Also, since people weren't able to travel for close to 2 years, many decided to buy a vacation home, a cottage, or an RV, which they will keep using (instead of going on foreign trips) even beyond the pandemic.

With that in mind, it is really hard to make sense of why HST is priced at pre-covid levels. Sure, if things work out well, 2022/2023 could be unusually strong years, but beyond that, the long-term prospects remain highly uncertain at best, and very bleak at worst.

Hotels have historically been the worst-performing property sector of the entire real estate market and given today's pricing and outlook, I would expect more underperformance from hotel REITs in the future.

SL Green (SLG)

SLG is the largest office landlord in New York City. Investors recently took a victory lap when the company announced a small dividend hike as well as a special dividend. It caused the stock to surge by ~6%, almost eliminating its recent losses, and if I was still an investor in the company, that's when I would have sold.

Data by YCharts

I believe that it is a bad policy to hike the dividend at a time when the company is facing significant uncertainty. Despite this recent victory lap, the NYC office market remains extremely weak with less than 30% of workers back in the office, near-20% vacancy rates, and falling rents.

We have previously explained that NYC is doing so poorly because a lot of companies are relocating to Florida and elsewhere to skip state income taxes and lower other business expenses. Meanwhile, the NYC office market is severely overbuilt, and as we continue to move to a hybrid work environment, companies won't need as much expensive NYC office space anymore.

source

This is a perfect storm that will likely hurt SLG for years to come, and the new Omicron variant news only adds more fuel to the fire. NY has already declared a state of emergency, putting more restrictions in place, and many major office tenants, including Google (GOOG), have already made headlines for delaying the return to the office.

With that in mind, if I had the extra cash, I would use it for deleveraging to reduce risk, but not for special dividend payments or dividend hikes. I suspect that the board made this decision prior to the Omicron news coming out, and may now regret it as this cash could have had a better use.

Unlike HST, you can at least make a case that SLG is discounted because it is currently offered at a 20% discount to pre-covid levels. We think that this discount is justified given what we know today, and therefore, we would consider selling into the recent strength.

2 Better Alternatives for Bargain Hunters

We aren't buying REITs like HST or SLG... But that doesn't mean that we are bearish on the entire REIT market. Quite the opposite, we think that REITs offer some of the best risk-to-reward in today's environment because:

• They are still discounted relative to most other investments.
• They offer high yield in a yieldless world.
• They protect against inflation in a money-printing world.
• They provide valuable diversification in a volatile and uncertain world.
• They offer substantial upside as we eventually recover from the pandemic.

But the key here is to be very selective. There are over 200 REITs and 20 different REIT property sectors, and while one REIT may be overpriced and risky, others are discounted and offer better prospects. Our specialty at High Yield Landlord is to identify the top 10% of REITs (VNQ) that offer a clear path to outperformance:

HST and SLG didn't make the cut, but we currently hold 25 other REIT investments. Two examples that we currently recommend include:

• Whitestone REIT (WSR): After briefly surpassing $10 per share, WSR is back in the low $9s due to the misconception that its properties will suffer long-term pain from the pandemic. We see it the other way. Yes, retail strip centers suffer in the near term, but because its assets are located in rapidly growing sunbelt markets, which benefited from the pandemic, WSR's properties are today more valuable than ever and set for above-average same property NOI growth in the coming years. In other words, this is a clear case of short-term pain for long-term gain, but since the market has missed it, WSR is still priced at a near 30% discount to pre-covid levels. While you wait for the recovery, you earn a monthly-paid near-5% yield.

• VICI Properties (VICI): VICI is currently priced near its lowest level in six months, and it is up only 7% in 2021, despite announcing transformative acquisitions and hiking its dividend by 9% in late September. Every day that passes, we are also getting closer to VICI closing on its MGP (MGP) acquisition, earning an investment-grade rating, and being potentially added to the S&P500, all of which, should serve as catalysts to push the share price higher. Right now, VICI appears to suffer deteriorating market sentiment because its recent results were impacted by the large share issuance that was done in anticipation of its MGP acquisition, but this temporary dilution will be short-lived and soon forgotten. Now is a good time to accumulate more shares at a near 20% discount to its all-time highs, and while you wait for the recovery, you earn a 5%+ dividend yield.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of WSR; VICI 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.