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REITs (VNQ) are back in vogue.
The market is now finally realizing that it had overreacted to the surge in interest rates and that the "higher for longer" narrative was nothing more than... well... a narrative.
The pandemic caused a temporary burst in inflation and interest rates were adjusted higher to fight it off, but they are now rapidly returning to much lower levels.
The debt market currently expects 200 basis point lower interest rates in just a year from now, and that's huge for REITs given that they are still heavily discounted after suffering a 2-year-long bear market.
Here are two examples of REITs that are enjoying strong rent growth and should greatly benefit from the rate cuts:
Dream Industrial (OTC:DREUF / DIR.UN)
Our Canadian industrial REIT investment is firing on all cylinders. Last year, it grew its FFO per share by 10.1% as a result of strong same-property NOI growth. That was the third consecutive year of >10% FFO per share growth for them.
And this strong growth is expected to continue because its current rents are still deeply below market.
The management estimates that its current rents are about 30% below market.
Dream Industrial
This has allowed the REIT to resign leases with 40%+ rent bumps as they expire, and this explains its 11% same-property NOI growth in 2023.
The management believes that this strong growth will continue:
"With our $7 billion industrial portfolio well-located in tight industrial markets with in-place rents approximately 34% below market rent and staggered lease maturities, the organic growth outlook embedded within our portfolio remains intact with less reliance on near-term market rent growth."
I really like this because it essentially means that the REIT has a "bank of growth" that it has already secured, and it also provides a margin of safety in case the fundamentals of the industrial sector deteriorate from here.
Even more remarkable is that despite enjoying one of the fastest growth rates in the sector, Dream Industrial is currently priced at one of the lowest valuation multiples:
| Dream Industrial REIT | US Industrial REITs | |
| P/FFO | 13.6x | ~20x |
It seems that the main reason for the discount is its external management structure. I agree that this warrants a discount, but I think that it is excessive here because Dream (DRM:CA) is a pretty good manager.
I have owned a few of their vehicles in the past and made great money on Dream Global when it was bought out by another company. This shows you that Dream is not just trying to milk fees, and they are willing to let you go at the right price because they are themselves heavily invested in the equity.
Moreover, they are not trying to raise capital at a discount to NAV to target dilutive acquisitions. Instead, they are now structuring deals with private equity players to leverage their platform and earn fees for their shareholders instead.
Another risk is the balance sheet. The REIT has a bit more leverage than its peers, but the difference is not significant. Its LTV is 36%, and it has a BBB investment grade rating. However, it has relatively short debt maturities that will likely impact its growth in the near term:
But as we noted in the introduction, interest rates are now expected to rapidly drop to lower levels, which could greatly improve their prospects in the coming years.
They still expect mid-single-digit FFO per share growth in 2024 and as rates are cut, this should be less of a headwind going forward. When you enjoy 10%+ same property NOI growth, and your LTV is just 36%, you can manage through even large bumps in interest expense.
Clipper Realty (CLPR)
Just like Dream Industrial, Clipper Realty owns desirable assets that are enjoying strong rent growth, but its valuation is held down by fears of how its interest expense will rise in the years ahead.
Clipper is an apartment REIT that focuses on NYC, with properties mainly in Brooklyn and Manhattan.
Clipper Realty
This NYC landlord reported another quarter of record revenue, NOI, and AFFO in Q2. Its rents are rising strongly, with new lease rates up 11% and renewals up 7%, demonstrating robust renter demand.
AFFO per share surged an astonishing 30.8% YoY, due in large part to abated taxes at one of its largest multifamily properties (Flatbush Gardens).
Even then, the company is today priced at just 8.5x AFFO and offers an 8% dividend yield that's very well covered with a low 60% payout ratio. That's a far lower valuation than its peers like AvalonBay (AVB) and Equity Residential (EQR):
| Clipper Realty | US Apartment REITs | |
| P/AFFO | 8.5x | ~16x |
What's the catch?
The first one is the debt. As we mentioned earlier, Clipper has quite a bit more debt than the average REIT, with its LTV at about 50%. However, the good thing here is that the company has no major debt maturities before 2027 and since it retains significant cash flow, it can gradually pay off its debt to reduce its leverage.
The second issue that's weighting down its valuation is that it also owns a few office buildings that represent about 20% of its cash flow and their future is highly uncertain because they will face significant vacancies as two tenants won't renew their leases.
The good news here is that CLPR just announced that it was in negotiations to renew one of them, but it is still seeking to re-tenant the other. Both leases expire a year from now, giving management plenty of time to find solutions and prevent extended vacancies. However, both may require significant capex for tenant improvements.
Obviously, that's not great, but given that the market has priced in a worst-case scenario, and the other 80% of its assets are doing very well, we think that the stock has become quite opportunistic.
The near term outlook continues to be clouded by uncertainties around its two large office leases maturing next year, but the long-term prospects look bright.
The REIT remains a high-risk, high-reward play with an 8% yield and 50%+ upside potential if things work out well for them.
Clipper Realty
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
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