The Outlook For 2022
- We're mixing high-level concepts with specific examples.
- This article will be focusing on our outlook for equity REITs.
- We will contrast some of the more and less attractive property types.
- Investors should beware capitalized expenses when evaluating REITs.
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We're answering a few major questions about our outlook heading into 2022.
What do you expect to be the key driver of stock market performance in 2022? What items will impact market performance - for better or worse?
For the market overall, I think corporate earnings will be a big story. That’s not particularly unusual. Let’s narrow it down to REITs. We have two broad categories for REITs, mortgage REITs and equity REITs.
For mortgage REITs we’ll be focusing on changes in the price-to-book ratios. The Federal Reserve’s actions can impact the amount of demand for different types of securities like Agency MBS and Treasuries. Consequently, policy from the Federal Reserve can impact book values. However, the mortgage REITs can see this coming far in advance. The story around price-to-book ratios can be more interesting. Emotion drives investors to buy and sell at the wrong times, which creates opportunities. You can find out about those mortgage REIT opportunities by reading Scott’s weekly updates. He includes a table that explicitly shows which shares have been upgraded or downgraded along with the current ratings and price targets for each share.
Moving on to the equity REITs, I think interest rates will play a smaller role than many investors expect. When interest rates increase, bond prices go down. However, many investors think that dividend yields must also increase, therefore REIT prices would go down. That simply isn’t the case. While some types of equity REITs have some correlation to Treasuries, the evidence for correlation is shaky at best. The bigger factor for equity REITs should be similar to the factor for the market as a whole. It should be about growth in earnings, which means AFFO per share for the equity REITs. I’m going to focus on equity REITs in this update.
As we approach 2022, are you bullish or bearish on U.S. REITs? In terms of asset allocation, how are you positioned heading into the New Year?
We’re bullish on a handful of REITs, neutral on several others, and bearish on REITs where we think future cash flows from the real estate will disappoint investors. Sorry, that’s a terrible answer. Let me provide examples. The net lease REITs still trade at bargain valuations after delivering respectable growth in AFFO per share. I believe many of them will post better growth in AFFO per share (normalized for any accounting factors) than they did in 2021. Despite solid growth on the horizon, they trade below their average historical multiples. That’s a nice deal.
We’ve also been buying tower REITs over the last several months. American Tower (AMT) and Crown Castle International (CCI) are both trading roughly around the line where we switch between bullish and neutral (after a strong rally). However, they should both see another solid year of growth in 2022 and when the time comes I think guidance for 2023 will include yet another year of strong growth.
So what looks unattractive? I don’t like the valuation on shopping center REITs. They're priced as REITs positioned for solid growth, but I think they will struggle to generate strong enough leasing spreads and occupancy rates to drive strong growth. Many of their tenants are in the service industry. That theoretically protects them from some online competition, but those types of businesses have high labor expenses. Increases in wages reduce the incentive to open new locations for a labor-intensive business. That’s a significant headwind and I don’t think that long-term risk is priced into shares today. If wage growth plunges, that would help shopping center REITs.
Net Lease or Shopping Center REITs?
Both of these types of REITs own primarily retail real estate. Both types of REITs try to avoid tenants who would be destroyed by online competition. So how can we like net-lease REITs and not like shopping center REITs?
Perhaps a few charts will help. Images are often better than words. I think in images. I don’t think in words.
We will compare Regency Centers (REG) with Agree Realty (ADC) and Realty Income (O). First, let’s consider valuation using "price to AFFO per share." I’ve already verified that I believe current consensus estimates on AFFO per share are within reason. Here are the AFFO multiples across the last five years:
Now you might think that this is simply the market correcting some mistake and REG was certain to trade at a materially higher multiple (nearly 22x for REG vs 17.7x for O and 18.3x for ADC). Maybe that’s your opinion, but you would think a higher multiple should go with higher growth. But how much growth did shopping center REITs see before the pandemic:
That’s not much. Prices today are similar to five years ago and AFFO per share climbed by about 13%. How does that compare to O?
Realty Income increased AFFO per share by about 28% during that period. What about ADC?
ADC was able to grow AFFO per share by 39% during that time.
Now some of our readers may understand that a REIT can enhance their growth rate in AFFO per share by retaining some of that AFFO for development projects. Some investors might think shareholders in O and ADC saw bigger growth in AFFO per share but the investor in REG is getting fat dividends. That isn’t the case. The yield on REG is 3.4%. The yield on O is 4.3% and the yield on ADC is 4.0%. The payout ratios are similar, around the mid 70% range (74% to 77%).
Over the last five years, excluding the pandemic, REG was slowly growing AFFO per share. ADC and O were growing it materially. Going into 2022, we expect to see these net lease REITs continuing to drive faster growth.
What’s the downside to net lease REITs? If inflation remains exceptionally high, the long leases create some headaches because some of the leases don’t include CPI or have a cap on the CPI adjustment.
How about office REITs? Bargain or trap?
Office space looks like malls from 2017. This isn’t just a call based on the valuation of office REITs. I simply don’t like the underlying property type. Office properties are notoriously difficult to lease with huge amounts of recurring capitalized expenditures. Even if a tenant can be replaced, it would be difficult to achieve a high enough rent to replace the prior tenant’s rent, cover downtime, and recover the capitalized expenditures. Work from home is coming. It’s substantially cheaper for the company because they don’t need to rent office space. Further, there is a huge pool of qualified applicants who are explicitly looking to work from home.
Want an example of how much work from home can alter an industry?
This article was prepared in my living room. Seeking Alpha is slaughtering expensive research services. While those companies have been slashing jobs for years, Seeking Alpha has been increasing rapidly. It isn’t just because Seeking Alpha stimulates demand by making the research easier to find. It’s because Seeking Alpha created an opportunity for analysts to work from home and reach a broad base of readers. While some small authors would jump at the opportunity to work for a major investment bank, the established authors wouldn’t have any interest.
Another example? Newspapers have been dying for years, but Substack is on the rise. The newspapers had huge fixed costs (salaries) for both productive and non-productive employees as well as huge office spaces. By taking the model to a work-from-home situation, they're enabling experts in the field to contribute (and get paid) while unsuccessful authors produce virtually zero cost. Guess where the talent goes?
Office work is dying rapidly and employers who demand the presence of their tech workers will be stuck paying higher salaries for less qualified applicants. How does a successful business pay significantly more to achieve comparable talent and then pay the office rent on top of it? I expect a substantial decline in the demand for office space over the next several years. It should be somewhat comparable to what we witnessed in malls from 2016 to 2019 as demand for space weakened.
Why is that a problem for office REITs? Because a huge amount of their recurring FFO (sometimes called Core FFO and I may use the terms interchangeably) goes to recurring capitalized expenditures. Let’s take a look at Boston Properties (BXP). This is a large office REIT with a great management team. How have they done over the last several years?
Source: Author’s Chart, data from REIT/BASE
Recurring FFO (or Core FFO) has grown at a strong clip. However, the Recurring FFO is calculated before removing adjustments for straight-lining rent or adjustments for recurring capitalized expenditures. Those are each significant differences between the Recurring FFO and what the REIT actually has available in cash. REIT/BASE AFFO deducts those values, which often results in a more useful value for analysis. In 2013, about 67% of Recurring FFO reached the REIT/BASE AFFO. In 2014 it was exceptionally high at 76.5%. However, in 2019 and 2020 it was less than 60%. The result is Recurring FFO per share growing 36% while REIT/BASE AFFO per share only grew 15.6% during that period. It looks like 2021 could provide some recovery, but the work-from-home pressure is just starting.
To provide further perspective, at $114.26, BXP is trading at 23.16x forward estimated “AFFO”. Note that I’m not saying REIT/BASE AFFO. I need to make that distinction because the consensus analyst estimate of $4.93 doesn’t look realistic when the best year historically was 2019 at $4.28. For 2021 they're on pace to land somewhere around that range depending on their recurring capitalized expenditures in Q4 2021. Guidance from BXP calls for projected FFO to increase by 13% from 2021 to 2022. However, the 2021 projection is held down by including a $.25 charge on debt retirement. If we strip that out the growth rate would be 8.7%. That sounds good. It sounds very good. However, to reach $4.93 in REIT/BASE AFFO, we would need to be looking at somewhere around 14% to 17% growth year over year. That’s improbable, in my opinion. If we were calculating the price to AFFO multiple using REIT/BASE AFFO, we would be looking at a multiple higher than 23.16x.
Why are we using BXP? Because I did enough research into office REITs previously to be confident in their management team and they are large enough and transparent enough for us to easily access the data we needed to run those numbers. I wanted to be clear that I see this as a fundamental problem with office property, not a problem with weak management.
Are massive capitalized expenditures normal?
For office REITs, high levels of recurring capitalized expenditures are very common. This isn’t some kind of non-recurring one-off situation. While 2020 may have been slightly harder than normal, investors looking at office REITs need to be aware of these huge recurring capitalized expenditures. They are not the same as new developments. They're cash spent on keeping a property appealing. It's a real cost, but it eventually flows through depreciation so it doesn’t reduce metrics like "Core FFO." Our largest allocations are tower REITs and manufactured home parks, both of which have extremely low recurring capitalized expenditures. After that we have apartments (medium levels of recurring capitalized expenditures) and net lease REITs (extremely low). We tend to pick REITs where the underlying property type demonstrates reasonable (or stronger) growth in rental rates combined with very low recurring capitalized expenditures. Here are some examples:
You can see that the line for REIT/BASE AFFO is similar to the line for Core FFO and you can see that the lines clearly increase over time. If we just want to compare the percentages of Core FFO reaching REIT/BASE AFFO, we have the following comparison:
Note: No data for CCI in 2013.
One reason this can be important is that sometimes the consensus analyst estimate may not include the necessary adjustments for recurring capitalized expenditures. That can make some REITs look cheap as a multiple of consensus estimates for FFO or AFFO, when they aren’t really cheap. However, there’s a simple economic issue as well. If a larger portion of the REIT’s revenues can be used to enhance shareholder value (dividends, acquisitions, or development), that’s a more attractive business model.
Outside of those four property types, we also have some exposure to industrial, data center, and cold storage.
Which domestic/global issue is the biggest risk that could adversely affect U.S. markets in the coming year?
To combat wage inflation, we could see policies (monetary and fiscal) that drive a recession. That could hammer values. Other variants could create issues. I expect other variants will occur (well over 50% probability), but they're unlikely to have an enormous impact (less than 50% probability). Each announcement would most likely trigger a drop in the 3% to 10% range, but if the variants remain mild a quick recovery would be probable. Therefore, I see potential “solutions” to inflation creating a larger risk. I plan to have another article addressing this issue for subscribers.
This article was written by
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Analyst’s Disclosure: I/we have a beneficial long position in the shares of SUI, ESS, ELS, DLR, WPC, CONE, PSB, COLD, NNN, REXR, AVB, AMT, CCI, SBAC, TRNO, FCPT, ADC, MGP 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.
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