A Dislocation Between Fundamentals And Price In REITs

May 23, 2022 1:56 PM ETPG, TGT, WMT, VNQ41 Comments32 Likes


  • All things seem to be falling together, but the fundamental impact is quite diverse.
  • Certain sectors such as REITs are not likely to suffer margin compression.
  • In fact, early data indicates REITs are growing the bottom line at a nice pace.
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A fresh wave of pessimism has swept across the market, driven in large part by the weak earnings reports of Walmart (WMT) and Target (TGT). Inflation and supply chain difficulties caused their cost structures to increase rapidly such that margin compression led to a significant earnings miss despite healthy revenue growth from both companies.

Almost nothing was spared from the selloff that ensued with traditionally stable blue chips like Procter & Gamble (PG) falling over 5% in a single day. The major indices were all down multiple percentage points.

I think this selloff has generated significant opportunity. Allow me to first discuss this opportunity from a macro level, qualitative reasoning standpoint and then drill down to more specific areas that I think are clear winners

Inflation impact on earnings

Given the complexity of macro forces, it is difficult to extrapolate outward. I think the market is making a mistake in looking at the impacts on WMT and TGT and applying that evenly to the rest of the market. If we take a step back and look at it from a system-level, I think it is qualitatively provable that the extrapolated fear cannot be true - margins cannot compress throughout the vertical as a result of inflation.

I posit that the net effect of inflation on real earnings is neutral which means the nominal impact on earnings is positive.


For every buyer, there is a seller.

  • An employer is buying labor and the employee is selling labor
  • Retailers buy products from suppliers
  • Etcetera, you get the point

So, for every increase to cost for the buyers, the sellers have a proportional increase to revenues. In a perfectly smooth economy, the effect would quite quickly net out with everyone just having 8% more revenue, 8% more cost and therefore 8% more earnings.

  • $100 revenue à $108 revenue
  • $80 costs à $86.4 costs
  • earnings of $20 à$21.6.
  • Purchasing power of earnings - still $20 in real terms

The actual economy is of course not that smooth. Some levels of the industry verticals will have far better ability to pass on the inflation than others. Those with power may be able to turn 8% inflation into 20% increased revenues and those without power will suffer the cost increases without the ability to pass on those increases to their customers.

WMT and TGT in this particular period were companies with low pricing power. Their suppliers were able to charge them significantly more while WMT and TGT were either unable or unwilling to pass those higher costs on to their customers.

For every weak spot that has margin compression within a vertical, there are other parts of that vertical that are benefitting. Thus, it is simply not correct to extrapolate the weak margins of these companies to the entire S&P.

The net effect is just a big jumbling of profit margins. Some companies are suffering and others are winning, but overall the impact of inflation on real earnings should be about neutral.

Many of the winners are already quite clear. Anything early in the supply chain seems to be winning because they can increase prices but their input costs are only going up marginally.

  • Oil and gas companies have dramatically expanded margins
  • Commodity producers are making enormous profits
  • Manufacturers are in high demand

In each of these cases, however, the market already knows they are winning. As such the inflation-related success they are enjoying is not necessarily an opportunity.

I am far more interested in the less known beneficiaries. For the purposes of this discussion, a beneficiary is an entity that can raise its revenues significantly more than its costs.

I posit that REITs are the most overlooked beneficiary. The fact that REITs are increasing rental revenues is well known, but I don't think people realize how insulated their cost structure is. Expenses are barely moving, so the higher revenues are coming with higher-margin leading to impressive earnings growth which REITs measure in FFO/share.

A much-improved capital structure

Many people believe that REITs are susceptible to rising interest rates and it's a totally understandable notion. REITs have historically been high leverage instruments with sloppy balance sheets. As such, the rising rates would increase their interest expense and largely offset the revenue increases from rental rates.

However, REITs have stepped up their game. After getting burned in the financial crisis, REITs have lowered leverage and carefully structured their debt. Interest expense as a percent of NOI has dropped from ~37% to ~18%.

Chart, line chart Description automatically generated


As it stands today, REIT balance sheets are well prepared for precisely this environment. Here are the numbers:

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S&P Global Market Intelligence

Only 7.5% of REIT debt is short term and only 13.6% of REIT debt is a variable rate.

This means that 92.5% of REIT debt is long-term and 86.4% is fixed rate.

Long-term fixed rate debt does not get more expensive as rates rise. It will eventually when they have to roll it, but there is a good 5+ year cushion in which REIT cost structures are largely fixed.

As a result, REITs are getting to raise rents and there is minimal cost increase to offset this. Margins have expanded with FFO as a percentage of revenue increasing to 41.4% in 1Q22.

Higher revenue and higher margins have led to substantially higher FFO. FFO/share for REITs increased 30.3% year over year in 1Q22.

Graphical user interface, table Description automatically generated


Note that 1Q21 was still being impacted by the pandemic so we should recognize that it was an easy comp. That said, the quarter-over-quarter numbers back up the growth with an FFO/share increase of 7.6% quarter-over-quarter.

Most of this growth came from a combination of occupancy growth and rental rate increases resulting in the highest same-store NOI growth in decades.

Chart, line chart Description automatically generated


Some of this is of course still post-pandemic rebound, but FFO as a whole is already well above pre-pandemic levels. NAREIT calculates 1Q22 FFO as 9.6% higher than the pre-pandemic 4Q19.

The opportunity

REIT fundamentals are the opposite of TGT and WMT's quarter and yet REITs fell in sympathy, down 14% in just the last month.

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As a value investor, this is precisely the setup that I like. Increasing fundamental value against a backdrop of freshly cheap market prices. The mean and median REIT now trade at 81.4% and 81.3% of net asset value (NAV), respectively. Historically, REITs tend to fluctuate between 95% and 105% of NAV. They are unusually cheap right now and I really like the fundamental outlook.

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This article was written by

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