Mission Critical REIT Investing

Summary

• Always follow the money and pay close attention to underlying cash flows that will in turn drive shareholder returns.
• In this article, I will explore the "mission critical" aspect to intelligent REIT investing.
• Nobody wants to own a "buggy whip" REIT portfolio.
• Be smart. Be tactical. Be disciplined. And be DIVERSIFIED!
• Looking for more investing ideas like this one? Get them exclusively at iREIT on Alpha. Learn More »

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“Mission critical.”

We heard a lot about that during the first months of the pandemic. In some places, it was more like the first year and a half.

Don’t recognize the term? How about we use the synonymous “essential services” instead.

All of a sudden, it rings a bell. Right? Perhaps you even read the USA Today article published on March 21, 2020. Titled “What Is Essential and Non-Essential During a Pandemic?” it answered its own question like this:

“With California, New York, Illinois, Ohio, and Louisiana ordering the closure of non-essential businesses and all non-essential workers to stay home – in an attempt to prevent the spread of the coronavirus – you might be asking yourself, ‘What is essential?’

“Federal guidelines give state and local authorities leeway in what they consider essential businesses during an emergency. But in general, those industries identified as essential include grocery stores and food production, pharmacies, healthcare, utilities, shipping, banking, other governmental services, law enforcement, and emergency personnel.

“‘The broad view is healthcare, obviously that is essential; sanitation [and] food is essential; and military is essential,’ said Jerry Hathaway, a New York City attorney with Faegre, Drinker, Biddle & Reath.

That leaves out a very large swath of businesses. Though several major companies managed to stay open anyway.

Walmart (WMT), Target (TGT), Lowe’s (LOW), Home Depot (HD)… They got the “mission critical” title. In which case, they were the lucky ones.

Perhaps inappropriately so.

The Dispensable Nature of Mission Critical Interpretations

Now, I get it. In a killer-virus-raging scenario, you don’t have to go to a restaurant. Or an amusement park. Or a movie theater, the gym, or a mall.

Especially not with the wonders of the modern internet age making so many things available at the click of a button.

But speaking of which… You could make a very real argument that the four companies mentioned above didn’t have to be open. Most areas with Targets and Walmarts, after all, also have more than one grocery store to rely on.

And do you really think all those construction companies building new homes were walking into Home Depot or Lowe’s with shopping carts to supply their business needs? I’m pretty sure both stores could have been run as delivery and “takeout” operations every bit as much as the restaurants that weren’t allowed to open their doors.

With that said, I don’t blame the many businesses that did their best to pose as “mission critical.” They didn’t want to close down. They wanted to keep making money, paying their employees, securing their future, and/or doing what they love.

In some cases, they were doing what they’d sacrificed for years – even decades – to build, grow, and maintain. The number of companies that crashed and burned due to the shutdowns was tragic. And the debate continues to this day on whether or not these losses were worth it in the end.

I’m sure that debate will continue down below in the comments section.

Naturally though, that’s not the point of this article. My point is to highlight mission-critical real estate investment trusts, or REITs, that can survive – and even thrive – through another such tragedy.

Because we all know another such tragedy could happen any time.

The Indispensable Nature of Mission Critical Interpretations

At the risk of getting (or remaining) controversial, Yahoo ran an article on Friday (January 27) that stated in its opening lines how:

“The National Institutes of Health failed to provide adequate oversight of an American organization that funded controversial research at the Wuhan Institute of Virology in China, according to a new government report...”

Issued by the inspector general of the U.S. Department of Health and Human Services, it admittedly “says nothing about” Covid-19’s origins. “For the most part,” this research happened “well before” the known pandemic began “in China in late 2019.”

However:

“The report is evidence of ‘major failures in past NIH oversight of high-risk research on enhanced potential pandemic pathogens,’ Rutgers molecular biologist Richard Ebright told Yahoo News in an email.”

Major safety-related mistakes were likely made. In which case, they can be made again.

To quote the article one more time, “‘The entire picture starts to look extremely disconcerting,’ mathematical biologist Alex Washburne told Yahoo News.” This is especially true considering how we learned months ago [from MSN] that:

“A team of Boston University scientists claimed that they have made a hybrid virus – combining Omicron and the original Wuhan strain – that killed 80 percent of mice in a study, according to DailyMail.com.”

In other words, government-funded deadly disease research continues today, perhaps to unnecessary degrees. And it definitely can take just one slipup for such research to do a world’s worth of damage.

I’m not advising you to panic, mind you. Don’t go dumping everything that doesn’t seem “essential” from your portfolio. But perhaps it’s time to consider the term more closely.

A lot of companies talk about having “mission critical” operations. But the three examples below can talk the talk and walk the walk.

Medical Properties Trust, Inc. (MPW)

Does this look mission critical to you?

Palmetto General Hospital (Medical Properties Trust)

MPW is an internally managed REIT in the healthcare sector and primarily invests in hospitals. They have 434 properties, approximately 44,000 licensed beds, are in 10 countries, and lease properties to 54 operators.

MPW leases its properties on a triple net basis, which reduces the expenses that they are responsible for. Triple net leases put the onus on the lessee to pay most expenses on the property, including taxes, insurance, and maintenance.

MPW - 3Q22 Supplemental

While hospitals make up the bulk of MPW’s assets, they also invest in other medical properties such as Behavioral Health Facilities, Inpatient Rehabilitation Facilities, and Urgent Care Facilities.

General Acute Care Hospitals is their largest category, representing 70% of MPW’s gross assets and 73% of MPW’s total adjusted revenue.

MPW - 3Q22 Supplemental

Hospitals are mission-critical properties. No matter what’s going on in the economy, how big e-commerce gets, or even a pandemic that shuts everything down – Hospitals must stay open.

Generally speaking, no one goes to the hospital because they want to, people go because they must, and while hospitals might not be considered trophy properties, they are a necessary component to society. There are several types of properties that can be considered mission-critical, but none more so than hospitals.

There have been several short campaigns waged against MPW over the last year, most of them surrounding their largest tenant, Steward. In 2022 MPW was accused of overpaying for properties in leaseback transactions and issuing loans to Steward in order to help Steward pay off their loans from their former private equity sponsor Cerberus Capital Management.

The basic argument is that without MPW’s financial assistance Steward would become insolvent, which would have a devastating impact on MPW as Steward makes up 29.5% of MPW’s annual revenue.

More recently, Viceroy Research issued a paper asserting many of the same claims previously made against MPW. In their paper, Viceroy Research claims that MPW issued billions of dollars of uncommercial transactions with its tenants and then capitalized the loans to inflate the value of their assets.

They go on to claim that substantially all of MPW’s major tenants appear distressed and reiterated the claim that MPW constantly overpays for distressed assets which allows tenants to meet their rent obligations.

While it is true that hospital operators have been under pressure since the pandemic due to labor shortages, wage increases, and regulations prohibiting elective surgeries, it appears some of these issues are starting to improve.

In their latest Investor Update, MPW highlighted this trend with Steward, stating that their financial results were substantially improving from the first quarter of 2022 due to expiring restrictions on elective surgeries in Massachusetts and that staffing cost pressures that have eased.

MPW Investor update

Another point to make is that the short thesis has not materialized in the actual numbers MPW is reporting. Since the pandemic began in 2020, MPW has had an average Funds from Operations (FFO) growth rate of 11.66% and since 2011 MPW has only had one year of negative FFO growth (2019).

FAST Graphs

Another key point is that there is a high amount of insider ownership. The Proxy Statement filed in April 2022 shows the CEO Edward Aldag owned 3.2 million shares and the directors and executive officers as-a-whole owned 1.21% of the total shares outstanding. It seems strange to me that the executives would make shady loans or unethical dealings with so much skin in the game.

MPW Proxy Statement

Medical Properties Trust is just one notch under investment grade with a credit rating of BB+. They have an adjusted net debt to annualized EBITDAre of 5.8x and 91% of their debt is fixed rate. Their weighted average cost of debt is 3.463%, and as of November 2022 they had approximately 1.2 billion in liquidity.

MPW pays a dividend yield of 9.22% that is well-covered by an estimated AFFO payout ratio of 82.27% in 2022 and has an average dividend growth rate of 3.79% over the last 10 years.

Currently MPW trades at a blended P/FFO multiple of 6.96x, which is the lowest multiple it’s traded at since 2009. We rate Medical Properties Trust a STRONG BUY.

FAST Graphs

Corporate Office Properties Trust (OFC)

Does this look mission critical to you?

Maritime Plaza (tenants include CSC, General Dynamics and SAIC) - OFC

Corporate Office Properties Trust is a self-managed REIT that owns and develops office and data center properties. The majority of their properties are in locations that support the U.S. Government and its contractors that are involved in national security, defense, and information technology (Defense / IT Locations).

OFC also owns office properties in urban submarkets in Washington DC and the Baltimore region, which they refer to as their Regional Office Properties segment.

As of September 30, 2022, 90% of their core annualized rental revenue came from their Defense / IT locations while 10% came from their Regional Office Properties. As of the third quarter in 2022, OFC portfolio includes 186 properties that cover 21.9 million square feet and were 92.8% occupied and 95% leased.

OFC Investor Presentation

While office properties might not come to mind when considering mission-critical real estate, OFC is mission-critical due to the high concentration of U.S. Government, defense, and cybersecurity clients they serve.

Corporate Office Properties Trust

OFC has an investment-grade credit rating of BBB- and reasonable debt metrics. Their net debt to in-place adjusted EBITDA ratio was 6.7x and their adjusted EBITDA fixed charge coverage ratio was 5.1x as of the third quarter in 2022.

92.5% of their debt is fixed rate and OFC’s weighted average effective interest rate is 2.85% with a weighted average maturity of 6.9 years. Additionally, they have no significant debt maturities until 2026.

OFC Financial Supplemental

Since 2013 the average annual growth rate on their Funds from Operations (FFO) is only 1.58%, but that is expected to improve to a growth rate of 3% in 2023 and 4% in 2024. Likewise, they have not delivered strong dividend growth with no increase in the dividend from 2013 to 2020 and then a dividend cut in 2021 from $1.10 to $0.83 per share.

The dividend is well-covered, with an expected AFFO payout ratio of 78.57% in 2022. Currently, OFC has a blended P/FFO multiple of 11.85x, which is slightly below their normal P/FFO of 12.68x. At iREIT, we rate Corporate Office Properties Trust a HOLD.

FAST Graphs

Digital Realty Trust, Inc. (DLR)

Does this look mission critical to you?

Austin, TX Data Center - Digital Realty

Digital Realty is a data center REIT that owns over 300 Data Centers, in over 50 metros with over 4,000 customers around the globe.

Data Centers are mission critical as they are a substantial component to the digital infrastructure that is becoming increasingly important. Data centers enable cloud computing, data storage, and e-commerce transactions and are part of the “e-commerce trifecta” along with cell towers and logistic warehouses.

DLR Investor Presentation

There has been a long running concern that hyper-scalers will build out their own data centers, reducing or even eliminating their reliance on data center REITs. In 2022 the well-known short-seller Jim Chanos stated that hyper-scalers will go from being Data Centers’ largest tenants to becoming their largest competitors.

That sentiment seemed to take hold as DLR’s stock has fallen much more than the broader market over the past year. Over a one-year period, DLR is down 25.19% vs a 7.91% decline in the S&P 500 (using SPY as a proxy).

Google

However, as the stock price has fallen, DLR’s fundamentals have improved. They achieved historical bookings in the third quarter of 2022 with total bookings of 176.1 mm.

Similarly, DLR had an increase in its Funds from Operations of 3% in 2022. Growth in FFO is expected to come in at 3% in 2023 and then accelerate to 6% and 7% in the years 2024 and 2025, respectively.

DLR Investor Presentation

Digital Realty is investment-grade rated with an S&P Credit Rating of BBB. Their Net Debt to Adjusted EBITDA is a little higher than I’d like to see at 6.7x, but they have no problems servicing their operating debt obligations with a Fixed Charge Coverage ratio of 5.5x. 80% of their debt is fixed rate, 97% of their debt is unsecured and they have a weighted average maturity of 5.4 years.

DLR Investor Presentation

DLR currently pays 4.46% dividend yield and has had consistent dividend growth with 17 consecutive years of increases. Over the last 17 years DLR has had an average dividend growth rate of 10.20% and currently has an expected AFFO payout ratio of 77.46% in 2022.

DLR Investor Presentation

FAST Graphs (DLR dividend growth rate)

Digital Realty currently trades at an FFO multiple of 16.22x, which is a discount to its normal FFO multiple of 17.87.

Given the mission critical nature of Data Centers along with positive signs of continued growth and the impressive dividend track record, at iREIT we rate Digital Realty a STRONG BUY.

FAST Graphs

In Closing…

Everyone has their own definition of “mission critical,” and while we can argue whether or not these 3 REITs are deemed “critical” to your investment portfolio, I must make it clear to you that I consider REITs mission critical to your overall investment portfolio.

I’m now spending most every weekend working on my new book, REITs For Dummies, which should be finished in early summer.

I’m excited for the opportunity to be the author of yet another book on the topic of REIT investing, and I’m most thrilled for the opportunity to assist readers with designing and constructing an intelligent REIT portfolio.

Recognizing that rates are impactful to REITs, I believe that shares have been oversold (for the most part) and now is a terrific time to put your hard-earned capital to work.

I must warn you though, now is not the time to chase yield, and while you may become tempted with high yielding opportunities, like Annaly (NLY) and EPR Properties (EPR) – to name a few – the prudent REIT investor should always pay close attention to fundamentals. I just finished reading a book titled Unconventional Success by David F. Swensen and he writes,

“Sustained levels of high cash flow lead to stability in valuation, as a substantial portion of asset value stems from relatively predictable cash flows.”

On other words, always follow the money, and pay close attention to underlying cash flows that will in turn drive shareholder returns. You can own a powerful portfolio of high-yielding REITs that generate steady and predictable sector-leading total returns. REITs have traditionally been well-positioned to take advantage of economic recoveries.

Nareit

While past performance is certainly no guarantee of future success, REITs deserve a sizeable allocation to your retirement portfolio.

Be smart...be tactical...be disciplined...and be DIVERSIFIED!

As always, thank you for reading and commenting, and I look forward to your comments below.

Disclosure: I/we have a beneficial long position in the shares of DLR, MPW 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.