VNQ - 2 Blue-Chip REITs At Big Discounts

2023-06-05 08:05:00 ET

Summary

• Real estate is the worst-performing sector of the stock market over the last year as the market has shunned REITs.
• Over the long term, however, REITs have consistently been strong performers.
• As REITs are being dumped like garbage, we sift through the rubble to find two blue-chip REITs that are now deeply discounted.

Co-produced by Austin Rogers for High Yield Landlord.

Real estate, and especially real estate investment trusts ("REITs"), seem to have become the least popular sector of the stock market. And it isn't even that close. As tech stocks ( VGT ) surge and consumer discretionary stocks ( VCR ) mount a comeback, real estate stocks ( VNQ ) continue to sit near their multi-year lows.

Everyone knows that the business model of real estate investment relies on debt to leverage returns on equity. Famed real estate investor Sam Zell once commented that investing in real estate without debt is like entering a boxing ring without gloves. Stock investors know this, and they also know that higher interest rates are a headwind to REITs. In the coming years, unless interest rates drop from here, a huge wave of real estate debt that was taken out during the low interest rate years of the 2010s will mature and need to be refinanced at significantly higher interest rates.

This widely understood factor along with the media's continual equating of "commercial real estate" with office buildings has led to severely negative sentiment against REITs.

Since stocks peaked in early 2022, the S&P 500 ( SPY ) has lost only about 12% of its value (rebounding 10% year-to-date!), while REITs have shed nearly 1/3rd of their value.

But this downturn does not reflect REITs' long-term performance track record.

Take a look at the total return performance table below. Over the last 50-year and 40-year periods, equity REITs have turned in the highest and second highest total returns, respectively. And that includes REITs' ~20% negative returns over the past year .

Commercial real estate has traditionally generated strong total returns from multiple sources:

• Growth in net operating income and cash flows from rising rent rates
• Property price appreciation
• Tax advantages such as depreciation reducing taxable income.

What about interest rates? Some investors who are critical of REITs say that they could only generate such strong long-term returns because of falling interest rates.

This is a misconception .

It's not that REITs don't benefit from falling interest rates. They do. But periods of rising interest rates correlate strongly with robust economic growth, which in turn correlates strongly with rising rents.

This cycle is no different. Rent rates have risen more than interest expenses!

What about the problem of low occupancy and loan defaults for office buildings?

Keep in mind that office REITs make up less than 5% of the broad real estate index. The biggest way they are detracting from overall REIT performance right now is by weighing down investor sentiment.

At High Yield Landlord, we argue that this environment is the perfect backdrop to hunt for diamonds in the rough -- high-quality REITs with top-tier assets, superb management teams, and strong balance sheets are today priced at the lowest valuations in years, often reflecting a large discount relative to the value of the properties they own.

Here are two of our favorite REIT diamonds in the rough.

Alexandria Real Estate Equities, Inc. ( ARE )

Often misclassified as an "office REIT," ARE owns, operates, and develops Class A life science properties in the most productive, top-tier research clusters in the United States such as Boston, San Francisco, New York City, San Diego, Seattle, and the Research Triangle in North Carolina.

Around half of ARE's tenants are either investment grade rated or large publicly traded corporations or both. Examples include Moderna, Inc. ( MRNA ) and Pfizer Inc. ( PFE ).

As you can see from the industry mix on the left above, almost all of ARE's tenants are biotech or pharmaceutical companies that use the state-of-the-art lab facilities in ARE's buildings for R&D. This is dramatically different than the standard office space found in the portfolios of most other office REITs. Demand for high-quality and well-located life science space has been consistently strong historically and has only gotten stronger in the COVID era.

Looking at some of ARE's recent results proves this. Compared to the long-term average, ARE's Q1 2023 same-property NOI growth registered at 9% on a cash basis (versus the 10-year average of 6.6%) and 3.7% on a GAAP basis (versus 3.6%). This strong performance in SPNOI largely came from soaring rent growth of 48% on a GAAP basis and 24% on a cash basis.

A big reason why ARE's business model produces such strong results is its heavy use of triple-net leases, wherein the tenant pays for all or most of the property-level expenses like taxes, insurance, and building maintenance. This is how the REIT can put up an operating margin of 70% and EBITDA margin of 69%.

ARE also enjoys a strong, investment grade credit rating of BBB+, one of the highest credit ratings of any REIT. Part of the strength of ARE's balance sheet is in its well-structured debt maturity ladder, with a weighted average remaining term over 13 years (almost double its 7.2-year weighted average remaining lease term) and no maturities until 2025.

The REIT has established a strong track record of dividend growth of around 5-6% per year, retaining around half of its cash flow for growth investments.

Today, ARE trades at a price to AFFO (adjusted funds from operations) slightly under 16x, compared to its historical average valuation of 25.5x. By price to cash flow from operations, we can see that ARE hasn't been this cheap since 2014 and is trading at recessionary levels.

Could ARE take a minor hit to its bottom line during a recession? Sure. But we believe a potential hit is more than priced into the stock today.

As its valuation normalizes, we predict >50% upside potential and while you wait, you earn a 4.2% dividend yield.

Crown Castle Inc. ( CCI )

CCI owns the most extensive portfolio of telecommunications infrastructure assets in the United States, and the REIT is focused exclusively on the mobile data-heavy US market.

The portfolio consists of a little over 40,000 cell towers, ~120,000 small cell nodes, and ~85,000 route miles of fiber that all works together to promote seamless connectivity and communications.

One of the most attractive aspects of CCI's business model is that it is easy and cheap to add "tenants" to its tower and small cell infrastructure, which increases its cash yield on investment higher and higher as more tenants are added.

For example, the tower segment, CCI's longest held assets, now enjoy cash yields on investment over 12% as most of its towers now enjoy 2-3 tenants each.

CCI's AFFO per share and dividend growth has dropped to the low single-digits, where it is expected to remain through 2025, because of a spate of lease cancellations from Sprint. After being acquired by T-Mobile US, Inc. ( TMUS ), there is a site rationalization process underway that will end in 2025. Thereafter, management has stated multiple times that they believe CCI will return to 7-8% annual AFFO per share and dividend growth.

The market seems to doubt that CCI will ever return to growth, hence the steep selloff. But industry forecasts suggest that mobile data usage in the U.S. should continue to grow by double digits through the end of this decade as 5G takes full effect.

We find it difficult to believe that continued strong growth in mobile data usage won't require further infrastructure investments by carriers after 2025.

With CCI's heavy push into small cells, we believe all the pieces are in place for many more years of high single-digit growth after the headwind from the Sprint lease cancellations ends in 2025.

CCI also enjoys a strong balance sheet and BBB+ credit rating, an enviable quality in the current environment.

With a weighted average remaining debt maturity of 8 years (even longer after CCI issued 5- and 10-year notes at an average interest rate of ~5% in April), few maturities through 2024, and 91% of total debt now fixed-rate, CCI looks well-prepared to weather the current high interest rate environment.

CCI is available today at a dividend yield over 5.5%, and we believe it's a bargain for long-term investors considering its high-quality portfolio of infrastructure assets, high-credit balance sheet, and a probable return to high single-digit growth within a few years.

Bottom Line

At High Yield Landlord, we are fundamentally bottom-up value investors. Where others see only danger, we see opportunity.

Of course, we are selective . We don't just buy anything and everything that is cheap. But when an entire asset class is being shunned like REITs are today, we know there are some amazing opportunities to be found.

We believe that to be the case with Alexandria Real Estate Equities, Inc. and Crown Castle Inc., both of which operate high-quality, well-capitalized, and highly profitable real estate businesses. Both are more than capable of weathering the headwinds from higher interest rates for however long they last, and both enjoy long runways of growth from secular tailwinds.

We are happy buyers of these blue-chip REITs today.

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