Recent Weakness In REITdom Is Creating Attractive Value
It’s been a little while now since I’ve last purchased any REIT shares outright in the markets. The last two REIT purchases that I made were in May of 2017 I bought shares of STORE Capital (STOR) and National Retail Properties (NNN) on weakness. Since then, STOR, which was irrationally cheap at the time, has increased ~19% (plus its hefty, ~5% dividend). NNN’s share price performance is essentially flat since that purchase due to the recent sell-off in the REIT space. Although I have added a REIT share here and there via selective monthly re-investments since then, I haven’t made a real estate related purchase outright in the markets because of a combination of perceived overvaluation within much of the industry and interest rate headwinds. With that said, recent weakness in REITdom has caught my eye and I’m beginning to put together buy targets for many of the high quality names in this high yielding sector.
I expected rising rates in 2017 and I expect to see more of the same as we move forward into 2018 and beyond. I think the normalization process with regard to historically low interest rates is underway and this poses a threat to companies operating in high yielding, interest rate sensitive sectors like the REIT space. I think the recent tax reform bill passage only exacerbates this issue for shareholders of rate sensitive shares; what will likely be a boon to the economy could force the FED’s hawkish hand in an attempt to keep the economy from overheating.
Many market analysts and commentators attribute much of the current 9-year bull market run’s success to easy monetary policy. While I acknowledge that it’s surely not that simple, it’s also difficult to disagree with that basic premise. We’ve seen corporate debt rise with rates so low, causing many to cry foul with regard to rampant financial engineering. I’m not that cynical, but I do admit that low rates have been a tailwind for equities, especially those operating in the REIT sector due to the leverage associated with those business models.
It’s difficult to make the argument that higher rates will be bullish for REITs. In the triple net space, I oftentimes hear about rents rising alongside rates. In theory, this makes sense, though it relies on a slow and steady normalization process. I’m sure the FED understands the power that it wields and will continue to do its best to make data driven decisions and raise rates in a way that is not totally disruptive to the stock market and the broader economy in general. But, there are no guarantees of a slow and steady approach.
I think the market is rightfully attempting to digest the risk that rising rates pose for the REIT space in general, but the contrarian in me sees the bearish equity response and my ears perk up. Elsewhere in the markets, RSI’s are rising as bullish sentiment exudes from the market. I’m looking over my holdings and setting valuation based sell targets. I’m not overly concerned about calling a potential top amongst such bullish sentiment, but I am focused on protecting some of the massive gains that I’ve made in the last couple of years. I don’t necessarily think the market is in a euphoric stage that would be a real cause for concern, but it is difficult to find attractive valuations and I’m beginning to tactically lean towards cash and more defensive holdings because of perceived overvaluation.
When it comes to defensive holdings, I know many don’t think of REITs. Maybe I’m biased based upon personal experience, but in 2015, when the S&P 500 was essentially flat, my portfolio significantly outperformed, posting ~7% gains, because of my overweight exposure to REITs at the time. Obviously a flat year is much different than a bear market and it’s impossible to compare one year to any other because of the numerous variables involved in the total returns produced by the market during that period of time, but in general, a recession will likely require action by the FED (lower rates) and this bodes well for companies like REITs.
And whether you agree with me or not, regarding the potential defensive nature of certain high quality REITs, I think we can all agree that the best time to buy defensive names is into weakness. Buying dips of defensive, divided based names helps to make up for the general lack of growth in these spaces while allowing investors to make the most of abnormally high yields. The REIT sector as a whole has experienced weakness lately which is why I’m attempting to sift through the mess and potentially pick up some shares of some high quality babies cast away with the bath water due to interest rate related fears.
What’s more, I suspect that conservative investors will flock towards reliable yields in volatile markets. This played a role in the REIT sector’s outperformance in 2015. High yields are the name of the game when it comes to REITs and I think this will help to build solid floors under high quality REITs as their yields reach certain thresholds (relative to fixed income investments).
So, with all of this being said, I’d like to put together a list of my favorite REITs alongside my value driven price targets for each stock. I’m not quite ready to start moving significant cash into this sector quite yet, so the feedback I receive from this piece should provide valuable insights as I work through the due diligence process.
Anytime you write about REITs, you’d be remiss not to mention the crowd favorite in the triple net REIT space, Realty Income (O). I’ve been wary, and even critical of O’s valuation in the past, but I have to admit that O’s history with regard to dividend growth and total returns certainly attractive. O’s long history of strong shareholder returns should certainly mean that this company deserves a premium price because of its S.W.A.N. (sleep well at night) status for income oriented investors. Although I consider myself to be a dividend growth investor, I’m not 100% interested in income, which is why I sold Realty Income back in 2016 at $69/share. O’s premium price has risen too high, in my opinion, and with a tightening FED serving as a headwind for this interest rate sensitive company, I’ve been waiting for a 5% yield ever since. O has come close to that yield threshold on several occasions during moments of weakness since, but hasn’t quite gotten there. O’s recent sell-off into the low $50’s puts the 5% threshold back into the realm of possibility and I’m watching this stock closely, hoping for chance to get back in at my target yield.
Source: F.A.S.T. Graphs
When looking at REITs, I oftentimes use yield thresholds for price targets because, as I said above, at the end of the day investors are buying REITs for income. Sure, value plays a role in the total return that one can expect to receive from his or her investment, but still, the structure of REITs makes them synonymous with income. With all of that being said, I wouldn’t be much of a value investor if I didn’t at least take a look at a company’s relative valuation and factor that into my price target.
As you can see on the F.A.S.T. Graph above, O is trading at its lowest P/AFFO multiple since mid-2015. O is trading for 17.3x AFFO and 18.4x FFO. 17.3x AFFO is a stark difference than the ~25x AFFO that O was trading for in mid-2016, when I sold my shares. ~17x still represents a premium to its peers, but I’m happy to give O the benefit of the doubt. At $51, O will be yielding 5% and trading with an AFFO multiple of just below 17x. Considering that O traded with a FFO multiple of roughly 10x during the great recession, I don’t think 17x is particularly cheap, but I do think it is fair and I’m happy to pay fair value for a very high quality company.
Speaking of very high quality companies, another REIT that I’m currently taking a close look at is Ventas (VTR). I built my VTR position back in 2013 and after a couple of FRIPs into the name, I have a total cost basis of $52.72. Over the last couple of years VTR has traded up into the high $70’s twice, giving me really nice gains on paper. However, after the stock’s recent pullback, shares are trading less than 4% away from my cost basis and I’m considering adding to my position should I have the opportunity to lower it.
Source: F.A.S.T. Graphs
Like O, VTR is currently trading with its lowest valuation based upon FFO & AFFO since 2015. As we move through this list, I’m assuming that we’ll see this trend developing with the threat of a more hawkish FED really weighing on these names.
Unlike O, VTR doesn’t demand such a high pricing premium. VTR is trading for 13.1x FFO, which is much closer to its 2009 low of 7.9x. Rising rates certainly pose a threat to VTR’s stock price and the effectiveness of its business operations in the short-term, but over the long-term, I think the population demographic trends domestically really bode well for this company and I feel comfortable holding my shares.
As the baby boomers age, the burden on our nation’s healthcare system will increase. VTR stands to benefit from this (barring some sort of overwhelming legislative overhaul) due to its portfolio of high quality assets across the healthcare spectrum.
Source: VTR IR Website
I like VTR’s diversified approach. This is why I view VTR as a S.W.A.N. in the healthcare space; no other company offers investors such a wide and well balanced healthcare real estate mix.
National Retail Properties:
National Retail Properties is another REIT that I currently own. It’s in the triple net retail space with O, but has traded with a slightly cheaper valuation and a slightly higher yield in recent years. Because of these two factors, I bought NNN (alongside STORE Capital (STORE)) when looking to add to my real estate exposure in 2017.
I actually like NNN’s portfolio mix better than O’s. O has ~10% exposure to drug stores in its portfolio (one of its largest holdings) whereas, NNN is more focused on restaurants at the top of its portfolio hierarchy. Nevertheless, both companies have amassed an attractive and well diversified (with regard to location and industry) property portfolios and I like the idea of owning these names much more than I do buying and managing a single physical property myself.
I bought shares of NNN for $37.28 in May of 2017 and now that the stock Is drifting down towards that price, I’m considering adding to my position (I generally only like to add to non-core/high conviction secular growth picks when I’m able to lower my cost basis).
Source: F.A.S.T. Graphs
At $38, NNN would yield 5%. At that price point shares would also trade in the 15x FFO range, which I consider to be fair for a high quality name like NNN. National Retail Properties is a U.S. Dividend Champion on David Fish’s CCC list with an annual dividend increase streak of 28 years. NNN’s steak is actually a few years longer than Realty Income’s, which is 25 years. With that being said, O’s 10 year dividend growth CAGR is 5.2% and NNN’s is only 3%. O’s 9.3% annualized rate of return is also greater than NNN’s 8.6%, though NNN has been able to out perform its slightly superior peer in the recent past because it hasn’t carried such a high valuation premium and didn’t have to deal with such sharp multiple contraction.
As previously mentioned, back in May of 2017 when I initiated my NNN position, I also bought shares of STORE Capital. I bought those shares for $20.46 and have since added a few via monthly FRIPs, resulting in a total cost basis of $20.53. My timing on both NNN and STORE were pretty perfect last year; apparently the market agreed with me regarding their valuations appearing to be attractive because I came within a few days of nailing each stock’s 52-week low.
What’s more, it wasn’t just the market that agreed with me, but Warren Buffett as well. Berkshire Hathaway bought ~10% of STORE approximately 1 month after my initial purchase, in June of 2017. Having Buffett’s blessing really helped STORE throughout the rest of 2017, resulting in gains of over 20% for me (not counting the 5%+ yield I received), even after a recent ~7% pullback.
I really like STORE’s real estate portfolio. This company have an intense focus on experiential real estate and I think it has probable the least “Amazon-able” collection of properties in the triple net/retail based space. ~70% of STORE’s portfolio is dedicated to services, differentiating it from O and NNN which are more retail focused
Source: STORE IR Fact Sheet
This, combined with the fact that STOR had the lowest valuation of the triple net bunch (O, NNN, and STOR) back in May when I wanted to increase my real estate exposure, was why I bought shares of this lessor known REIT.
Even after the ~20% Buffett-bump, STORE still trades for ~15x FFO, making it much cheaper than Realty Income. STORE doesn’t have the history that O or NNN can boast, but as a more speculative, mid cap REIT play, I like having a bit of exposure to this Arizona based company. STORE isn’t a S.W.A.N. to me because of its relative youth, but I think it has a lot of potential to grow into something special.
Source: F.A.S.T. Graph
Link SA article about this purchas
When I starting putting this piece together I planned on discussing 10 REITs that I currently have my eye on. However, we’re already over 2,000 words, so I decided just to focus on the retail/triple net space (I’ll write another REIT piece focused on the other 5 that I’m considering separately). The final REIT that I’ll be discussing here is W.P. Carey (WPC), which is another S.W.A.N. type company (in my opinion, at least), so long as you’re interested in international real estate exposure.
~35% of WPC’s portfolio is located overseas (primarily in Europe, with the largest single country exposure, other than the U.S., coming from Germany, which represents ~7% of WPC’s holdings).
WPC’s portfolio is probably the most diversified of the 5 companies I’ve discussed in this article. Management has spread its exposure across a variety of industries, with retail amounting to only 16% of its holdings.
Although WPC has a very impressive dividend increase streak of 21 years, this company is oftentimes looked down upon by investors who aren’t as interested in the international exposure. This is why WPC tends to trade at a discount to its peers with 20+ year dividend increase streams, O and NNN. It’s rare that WPC’s premium rises above 15x FFO. This relatively cheaper price si a good thing for value oriented investors like me. A depressed stock price also leads to higher yields which is why WPC is the highest yielding stock of the bunch that I’ve discussed today at 6.1%.
Source: F.A.S.T. Graphs
While I’m beginning to like some of the prices that I see in the REIT space, I haven’t made any purchases in the sector yet in 2018. I will continue to monitor my watch list and alongside improvements to the economy and any rhetoric coming out of the FED. Rising rates are a threat to REITs and I expect 3-4 in 2018. However, so long as the normalization process is slow and steady these names should be okay. This is especially the case for income oriented investors; I’ve seen estimates of the 10-year yielding 3.25% by year’s end…this is quite a bit higher than we’re used to, but still nowhere near the 5-6% yields that these REITs are currently offering shareholders.
Disclosure: I am long NNN, VTR, WPC, and STOR.