By SA Marketplace:
Markets have settled and recovered from the initial shock of the coronavirus spread and the response of governments around the US and the world to lock down the economy. But while the major US indices have approached, if not quite matched, the fabled v-shaped recovery, there are still plenty of questions left for investors.
The disconnect between the markets and the economy has become a cliche, which doesn’t change its validity. The size of stimulus in the US has been unprecedented. As governments start to reopen, it’s to be seen whether we will see a second wave of cases. And we don’t yet know how quickly people will go back to spending, and what the engine of the economy will be in this uncertain period.
To suss out all these uncertainties, we’re starting a second round of our coronavirus roundtable series. We’ll be looking at some of the major sectors of the market that are in the market, overall market and macro outlooks, and niches that may deserve investors’ attention.
We focus today on REITs. March’s volatility may have startled sector participants, but things have calmed down. At the same time, the sector as represented by the Vanguard Real Estate ETF (VNQ) is trading a little lower than it was last time we convened. And for the first time in a long time, a common statistic on earnings calls for the sector this quarter was just ‘rent collection percentage’. So how do things shape up? Our panel to discuss:
- Dane Bowler, author of Retirement Income Solutions
- Jussi Askola, author of High Yield Landlord
- Colorado Wealth Management Fund, author of The REIT Forum
- Blue Harbinger, author of Big Dividends PLUS
Seeking Alpha questions are in header font. Author disclosures are available at the end of the article. Questions were sent out on May 14th and answers sent back by May 17th.
Dane Bowler, author of Retirement Income Solutions: REIT earnings for the first quarter generally came in strong, but the economic effects of the crisis were not felt until late March so there were only a couple weeks of potential lost revenue. Thus, it was more the outlooks that were impacted rather than the quarter’s results. A large portion of REITs have eliminated guidance and instead given qualitative commentary on expected impact. Uncertainty is elevated.
Jussi Askola, author of High Yield Landlord: The main surprise is really how little rent is expected to be lost in the end. Early into this crisis, we saw a lot headlines of very low rent collection rates. In reality, the vast majority of REITs have reported over 90% rent collection, and the rest is expected to be paid at a later date. The exception is retail REITs which are experiencing more difficulties. But even here, the missed rent payments are not cancelled, they are simply deferred for a later date. We believe that the power of lease agreements have been underestimated by REIT investors who often have no real experience in real estate investing.
Colorado Wealth Management Fund, author of The REIT Forum: The panic in the REIT sector has been exceptional. A huge chunk of the S&P 500 acts like there is no recession, but most of the REIT sector saw valuations plunge. There are huge disconnects in valuation throughout some parts of the sector. Wall Street remains quite slow at updating NAV estimates on equity REITs.
Blue Harbinger, author of Big Dividends PLUS: We’ve learned that fear-mongering media pundits continue to promote indiscriminate selling thereby increasing the stark contrast between attractively priced and unattractively priced REITs. For example, mortgage REITs (mREITs) tend to be more challenging for many investors to understand, and they’ve been indiscriminately selling both the good and the bad, thereby creating some very attractive buying opportunities. For example, we warned investors of the dangers of mREIT New Residential (NRZ) less than two quarters ago in a controversial article. Unfortunately, we were exactly right as the dividend was slashed 90% and those shares are not returning to their pre-crisis level anytime soon. On the other hand, there are some extraordinarily attractive mREIT investment opportunities right now, as we have been sharing with members of our Marketplace service Big Dividends Plus. We’ll get into more detail on mREITs later in this report, but the ones that stand out have very safe balance sheet assets (such as certain types of mortgage backed securities), ample liquidity to weather short-term market dislocation (which the fed has been working overtime to address by pumping liquidity into the system) and strong transparent management teams.
Dane Bowler: Fundamental performance has been significantly bifurcated by property type. April was hit more than March and we think rent collection rates will bottom in May. Some are obvious such as retail REITs performing badly and data centers doing well, but others were unexpected and still not priced into the market. Apartment and manufactured housing reports came in with close to full rent collection which goes against some of the news reports suggesting people are boycotting rent.
Jussi Askola: Not all REITs are created equal. At High Yield Landlord, we invest ~80% of our Portfolio into defensive property sectors with limited collection issues. This includes apartments, manufactured housing, hospitals, medical offices, net lease, and industrial properties. We don’t expect major issues from these investments. Malls and shopping centers are facing more delinquencies, but it is important to understand why. We have closed the economy. People are sitting in quarantine and non-essential stores are closed. Therefore, as we reopen the economy, we expect rent collections rates to quickly recover. This is not a permanent, but a temporary issue.
Colorado Wealth Management Fund: It will depend on the subsector. We see more risk to long-term rent collection for office space and retail space. Both property types are at risk of a fundamental shift in demand. Investors should be sticking to the best-of-breed operators. Teams with good management, a strong record, and low leverage. Don’t go chasing yield. Investors who value a stock based only on the last dividend declared are setting themselves up for pain. REITs which own housing assets or industrial property should still have stronger pricing power. We see plenty of opportunity there as many of these REITs have plunged as well. We still want to stick to the stronger REITs though. In housing, investors may want to consider Equity Residential (EQR) rather than American Campus Communities (ACC). Apartments are less risky than student housing. Dorms put students too close together and a switch to online courses is a major threat. For students to take even a few terms online, the infrastructure needs to exist. If colleges build the infrastructure for online courses, they won’t want to give up the huge margins on additional students.
Blue Harbinger: Survival is increasingly a team effort between tenants and property owners. Specifically, if a tenant were to get evicted, there really isn’t anyone standing in line to take their place. Therefore, a lot of rent concessions are being made. In our view, some REITs may die a slow and painful death, such as Tanger Factory Outlet (SKT) whose demise has now been accelerated by the coronavirus. We warned investors about the dangers of Tanger back in a mid-February article. Since then, Tanger’s share price sell-off has accelerated dramatically. And regarding “slow and painful” deaths, this actually makes certain REIT bonds more attractive because it affords them the opportunity to keep paying their big coupon payments to investors through maturity in a few years (plus, they trade at attractively discounted prices because of unwarranted fear). One example that comes to mind is mREIT Starwood Properties (STWD), which this article does an exceptional job of detailing the opportunity in the bonds (which by the way, we have been buying in certain institutional/non-retail investment accounts). And if Starwood can survive this coronavirus mess, the common stock has enormous (albeit very volatile) rebound potential too.
Dane Bowler: We have re-positioned into REITs that are more fundamentally resilient but not necessarily being recognized as such in terms of market price. I think it is important to stay invested. There is just as much risk in missing the recovery as there is in hitting a second wave of selling. The next few quarters are murky, but it is more clear that there will be an eventual recovery. So if we know that at some point in the future REITs will be higher, staying invested is beneficial, even if there are many bumps and dips between now and that point.
Jussi Askola: We mitigate risks by being very selective. Out of ~200 REITs, we only invest in ~20 of them at High Yield Landlord. This means that we screen out REITs with overleveraged balance sheets, conflicted management teams, and unsustainable cash flow. The great majority of our REIT investments are in defensive sectors: apartments, manufactured housing, hospitals, medical office, net lease, and industrial properties. And even more importantly, our holdings have enough liquidity to survive an extended shutdown of the economy. Balance sheet quality is more important than ever.
Colorado Wealth Management Fund: The simplest way to handle the balancing act is to look for REITs that sold off, but which are only moderately exposed to the virus on a fundamental level. PS Business Parks (PSB) has zero debt. The only source of leverage is some preferred equity in their capital structure. That gives them a solid A- credit rating from S&P. They are an industrial REIT, which is a very favorable sector. The REIT usually has very high correlation with other major industrial REITs like Prologis (PLD). While Wall Street is officially “Bearish” on the REIT, the average price target is $140.40, indicating about 26% upside. Instead, Wall Street is bullish on PLD, where they see 13.3% upside. Not joking:
Data by YCharts
Sources: YCharts and Seeking Alpha
So what’s a dangerous REIT in this environment? Plymouth Industrial REIT (PLYM) is a polar opposite. Beyond the high volatility in the share price, the company simply has absurd amounts of leverage. During the 2018 market scare PLYM issued a substantial amount of preferred equity in a private transaction. The preferred equity was structured so most of the cost would flow through “amortization”. Amortization is a real expense (unlike depreciation). Running the cost through amortization creates inflated FFO per share.
Blue Harbinger: The coronavirus has accelerated trends that were already underway. For example, data center REITs (which have less “social distancing” challenges) have done well as enterprises continue to move to the cloud. One example is Digital Realty (DLR) which we own and wrote about back on December 27th. DLR is up significantly this year and is less impacted by shutdowns as compared to other REITs.
This roundtable is about REITs, but another way to balance the risk of prolonged/renewed shutdowns is to invest in some big-dividend payers that are NOT REITs. For example, BDC Ares Capital (ARCC), offers a 12% dividend yield and is trading at an attractively discounted price. Just yesterday, we released a detailed report on Ares for our subscribers. The idea is simply that shutdown risks (and many other risks) can be reduced by investing in a prudently diversified balance of big-dividend payers. And if you are curious, one of the reasons we like Ares is because a large portion of its portfolio is in defensive industries, such as healthcare services (~14%), software (~9%) and professional services (~7%), and it’s underweight the pandemic-sensitive industries, such as energy, travel, restaurants, hospitality and retail.
Dane Bowler: The damage to mortgage REITs is permanent but not recurring. The book value that was lost is unlikely to be recovered as the liquidity crunch forced margin calls on many mREITs which caused them to have to sell assets into a void of buyers. The remaining assets will likely bounce back a bit, but the losses that were incurred in the selling process will not be recovered. Going into the crisis we were strictly in equity REITs, but we have moved into some of the agency mREIT preferreds as they are trading at nice discounts to par and the lower leverage state of the companies makes the preferreds a bit safer.
Jussi Askola: Most mortgage REITs are opportunistic, but they are also very risky and unpredictable. We believe that traditional Equity REITs offer better opportunities and more predictable outcomes. We discuss this in greater detail in our recent article “The Dark Side of mREITs”.
Colorado Wealth Management Fund: Investing in mortgage REITs requires extensive due diligence. Investors see the high dividend yields and assume that they simply need to buy, hold on, and eventually be rewarded. There are plenty of rewards to be earned in the sector, but they aren’t earned closing your eyes and holding on tight. They are earned by forecasting changes to book value, updating targets, and trading against investors who don’t understand the rules of the game. That makes some people angry. They get bitter, instead of getting better.
This was a hard time for mortgage REITs, but it wasn’t impossible to turn a profit. To demonstrate our trades, alerts, and techniques, I prepared a huge image: Notice how the vast majority of our returns came from a change in the share price? Remember, the price of ETFs for the sector fell by more than 50%.
Blue Harbinger: The pandemic has already created distinct winners and losers in the mREIT space, although the market is still indiscriminately pricing almost everyone like a loser. They say during times of panic, mREITs take the elevator down, but slowly ride the escalator back up as emotionally and financially scarred investors gradually return to the space. Mortgage REITs generally use a lot of leverage (to buy mortgage-related assets), so the big risk during a market plunge is forced selling (at fire sale prices) to meet margin calls. That has already played out as liquidity dramatically dried up in the fixed income markets thereby causing even super safe government agency securities (e.g. Freddie and Fannie) to trade at distressed prices (which was a complete disconnect between the true safety/value of the bonds). Nonetheless the damage has already been done. Amazingly, select attractive big-dividend mREITs continue to trade at significant discounts, despite the fact that they own super safe assets, they were hit with no margin calls, they have plenty of liquidity, and the fed has taken a “whatever it takes” attitude to maintain liquidity and to support the very securities these mREITs own. We’ve made two select mREIT purchases in recent weeks.
Dane Bowler: I am fascinated by the way stocks are trading on sector news even after their individual performance has already been reported. Medical Properties Trust (MPW) is trading down on news reports about challenges to hospitals, but MPW has already reported successful collection of nearly all of its rent and its particular tenants are surviving. Essentially the strong EBITDAR coverage of its operators is being entirely overlooked.
Jussi Askola: We believe that all lease REITs are particularly opportunistic today. Generally, these are some of the most resilient REITs to own during recessions because they enjoy >10-year leases and high rent coverage. Yet, in the recent bear market, they sold off more than other sector, and many net lease REITs are now trading at their lowest valuations ever. This is especially surprising because interest rates have now dropped to 0% and net lease REITs are considered to be hybrids between equities and fixed income. Historically, they trade at a 200-300 basis point spread over the 10-year treasury. To reprice at these levels, a few REITs would need to double or triple in value. Spirit Realty Capital (SRC) is a good example with its 9% dividend yield.
Colorado Wealth Management Fund: We’re seeing a huge disconnect between the NAV (net asset value) for REITs and the public market pricing. For equity REITs, the NAV will often follow the direction of the share price. It won’t happen all the time, but it happens more often than not. See a REIT trading at a huge discount.
Check if it usually trades at a significant discount. If it usually trades at a large discount, you’ll probably see a negative trend in the share price and NAV. Why? Because it’s “cheap for a reason”. If it rarely trades at a discount, it is more likely to be an opportunity.
For mortgage REITs, prices generally do a poor job of predicting the change in book value. Prices may move before the change in book value is announced, but that doesn’t mean they move before book value. If you’re waiting for an announcement, you’re already disadvantaged. It’s like reading the scores for sports in the newspaper. Other people knew in real-time. There’s a word for the people who knew in real-time: Winners.
Blue Harbinger: We are watching a few themes in considering REITs. For one, as mentioned earlier, we believe the coronavirus is accelerating the ongoing demise of many of the weaker retail REITs. We also believe the coronavirus is forcing more enterprises to move to the “social-distancing benefits” of operating in the cloud, and this benefits data center REITs (such as Digital Realty and CyrusOne (CONE)). Further, we like select industrial REITs that are part of the ecommerce supply chain as social distancing accelerates the shift to online shopping. For example, big-monthly-dividend-payer STAG Industrial (STAG) is interesting in this regard, as we recently wrote about in detail here. Lastly, certain REIT bonds (such as Starwood bonds) are very interesting because they mature relatively soon, they trade at attractively discounted prices, and they offer big coupon payment that are secured by cash flows and physical assets.
Dane Bowler: I feel better about the prospects now because data has come in stronger than expected. Rent collection for the weighted average REIT is strong. Yes there is struggling among retail REITs and hotel REITs, but these sectors are a very small portion of the overall REIT universe. The large weights in the REIT sector are towers, data centers and residential REITs, all of which are performing well.
Colorado Wealth Management Fund: Significantly better about equity REITs. We’ve seen some positive developments at the macro level, thinning credit spreads, and an increase in the S&P 500. Those factors all point to higher valuations for REITs.
Blue Harbinger: It’s a stock-picker’s market for REITs now more than ever. It’s very important for investors to use prudent benchmarks (such as VNQ) to measure performance, but it’s also important to not lose site of the attractiveness of individual investment opportunities, as many ETF investors are increasingly doing. We feel better about some REITs than we did 6-weeks ago, and worse about others. For example, the ongoing transparency that some mREITs have been providing (in addition to quarterly earnings announcements) has been helpful (and in some cases encouraging). However, the growing talk of a second and third wave of coronavirus outbreaks makes several of the themes we discussed earlier even more pronounced in terms of winners and losers. Also, critically important, investors should never become overly confident in their stock picks because the market can humble you quickly. That’s why we continue to believe in the importance of selecting attractive investment from across categories, not just REITs.
Dane Bowler: Yes, we continually adjust out portfolios to capture divergence between fundamentals and market price. In particular I have been adding to discounted preferreds of stable REITs and those whose good reports went unrecognized in market pricing such as Iron Mountain (IRM) and Gladstone Commercial (GOOD).
Jussi Askola: Yes, we have been loading up on apartment REITs at High Yield Landlord. They provide some of the best risk-to-reward in this environment. Class B apartments in sunbelt markets are doing much better than initially expected. Rent collection rates have been close to 100% and yet, these REITs have not seen any recovery in their share prices. It reinforces our investment thesis in Independence Realty Trust (IRT).
Colorado Wealth Management Fund: We recently added to our positions in Equity Residential (discussed already) and Essex Property Trust (ESS). Both are apartment REITs with very strong financial positions and excellent management teams. The apartment sector usually trades much closer to NAV, but the discounts are substantial. We expect projections for NAV to decrease moderately over the next month, but the discounts would still be large.
We put together a batch of charts demonstrating several core features for the apartment REITs:
You may notice that “Price-to-NAV” and the “FFO or Core Multiple” both generally correlate with risk ratings. The only major standout is Mid-America Apartment Communities (MAA), which benefited over the last year from investors liking non-coastal focus, which is relatively rare in an apartment REIT. Why does Clipper (CLPR) get such a low multiple and price-to-NAV? Emphasis on New York (big virus impact) and extremely high leverage. If New York property values decline, CLPR could have a hard time rolling over their debts.
Blue Harbinger: We are long-term investors, and we don’t trade often. However, we recently sold two big non-REIT winners to make room for a couple of very attractive mREITs. If you are curious, we sold big-dividend winner Tekla World Healthcare (THW) after benefiting from its huge dividend payments for years, and we also sold some Netflix (NFLX) because we believe in the importance of generating some of our income through growth (and Netflix has generated a huge amount of “income via growth”). We moved that money into two new mREIT investments because the opportunities in the space are quite compelling.
Dane Bowler: In the April addition of the REIT marketplace roundtable I pitched Uniti Group (UNIT) along with a bunch of preferreds, specifically GNL.PA, FPI.PB, AFINP, GMRE.PA and UMH.PD and I am happy to report the underlying REITs all reported excellent numbers. UNIT’s lease amendment has been approved by the judge, GNL and GMRE each had 98% rent collection in April, FPI grew revenues on a same store basis with seemingly no interruption from the virus, AFIN’s rent collection came in vastly ahead of other retail REITs, and UMH had double digit same store NOI growth. Market prices have come up a bit for most of these preferreds, but the resilient fundamentals suggest each of these preferreds will return to $25 par which is still a fair bit of upside.
Jussi Askola: No major changes. In full transparency, we don’t take quarterly results too seriously at High Yield Landlord. We monitor results, but it is rare for us to change an investment thesis based on a quarter or two. In a world where most analysts focus on next quarter’s results, our “landlord” mindset differentiates us from the rest. Instead of we focus on five-year averages. We are landlords, not traders.
Colorado Wealth Management Fund: Last time we highlighted a trade we had just made. We swapped shares of TWO-B (TWO.PB) at $16.86 for shares of TWO-A (TWO.PA) at $16.80. Both were in our strong-buy range, but we were confident shares of TWO-A offered a better deal. Due to the difference in the prices ($.06 per share), we were able to turn 346 shares into 347 shares with the same total investment. Since TWO-A carried a higher coupon rate today and would have a higher spread when the floating rate kicks in (that’s 4/27/2027), we were getting an instant upgrade to our income. It wasn’t hard to decide that we would rather have our preferred share position pay $704.84 per year rather than $659.56. We sold TWO-B at an 11.56% yield and bought TWO-A at a 12.42% yield. We theorized that we would see the price of TWO-A outperform as the market caught on. That played out precisely as expected. Shares of TWO-A are now $20.70 while shares of TWO-B are $19.05. We trade positions in the preferred shares whenever we find an opportunity like that. We intend to continue finding those opportunities and taking those trades whenever possible. Our other callout in the article was NLY-I (NLY.PI) which traded at $19.50 when we prepared our answers and closed at $20.85 as of Friday 5/15/2020 (up 6.9%).
Thanks to our panel for their insights on the interesting times in the REIT sector. Check out their work at the links above.
We’ll be continuing this series this weekend with a look at tech. Any requested areas of focus? Please let us know below or at premiumauthors at seekingalpha.com.
See also Occidental Petroleum: What Icahn Knows That You Don’t on seekingalpha.com
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.