WPC - 2 REITs All Investors Should Buy

2023-12-19 08:05:00 ET

Summary

• REITs recently reported strong 3rd quarter results.
• Despite that, they remain heavily discounted even after the recent rally.
• Here are two of our top picks for 2024.

The real estate investment trust, or REIT, earnings season is now over, and the results were surprisingly strong, with most REITs beating expectations.

Here are some examples:

• STAG Industrial ( STAG ) just reported record cash rent increases of 39.3% in the quarter, despite fears of oversupply in the industrial market.

• VICI Properties ( VICI ) boosted its 2023 guidance on the back of strong acquisition volumes and it is now guiding to grow its adjusted funds from operations, or AFFO, per share by 11% this year alone.

• Essential Properties Realty Trust ( EPRT ) also hiked its 2023 guidance and guided for consistent growth in 2024 and 2025, despite the surge in rates.

• EPR Properties ( EPR ) also lifted its guidance and noted that its theater's rent coverage is now near pre-pandemic levels.

• Alexandria Real Estate ( ARE ) boosted its guidance and is now expecting to grow its FFO per share by ~7% this year.

• And there are many other examples...

As a result, share prices have recovered a bit in recent weeks, but overall, REITs are still down over 30% and valuations are still near their lowest in a decade:

There's a clear disconnect between fundamentals and share prices.

For the past year-and-a-half, REITs have behaved like bonds and the poor market sentiment has pushed REIT share prices to much lower levels even as most of them kept growing their cash flows.

As we have repeatedly explained, REIT balance sheets are the strongest they have ever been with LTVs at just around 35%, long debt maturities, and the high inflation and elevated interest rates have led to significant rent growth.

Therefore, the impact of rising interest rates isn't nearly as significant as the market appears to believe and the latest results are further evidence of that.

We think that this is a historic opportunity to buy real estate at a heavily discounted price, and in what follows, we will highlight two of our Top Picks for 2024.

Camden Property Trust ( CPT )

Camden Property Trust is an Apartment REIT that focuses on rapidly growing Sunbelt markets. It has a fortress A-rated balance sheet , a fantastic track record, and its properties have gained significant value over the past years.

Even then, its share price has been cut in half!

Its recent quarterly results slightly surpassed expectations, but its stock dropped nonetheless because the company noted that it is starting to feel the impact of new supply and expects its growth to suffer in the coming quarters.

Mid-America Apartment Communities ( MAA ), a close peer of CPT, made the exact same remark on its earnings call , as it also noticed a deceleration in its rent growth.

But it is very important to note that this should be just temporary. Here's what MAA's CEO said on their earnings call (emphasis added):

"The volume of new apartment starts has begun to decline, and we expect that leasing conditions will be supportive of higher rent growth in late 2024 as markets absorb the current development pipeline."

He thinks that rent growth will accelerate a year from now, as new development projects have been put on halt due to the higher interest rates and elevated construction costs.

It is also worth noting that CPT focuses mainly on Class B properties and those are less affected by the new supply. MAA appears to be more heavily impacted, which is expected given that it is more heavily invested in Class A properties:

In any case, a few quarters of flattish growth do not justify such low valuations. CPT is currently priced by the market at a ~7% implied cap rate, but its assets would likely sell at a 5% cap. In fact, AvalonBay just bought a property in Dallas at a mid-4 cap, and UDR, Inc. ( UDR ) also recently bought a sunbelt portfolio in the mid-4s.

What this means is that CPT is priced at around 60 cents on the dollar, which is truly exceptional for an A-rated blue chip apartment REIT like CPT.

Factoring the 4.5% dividend yield, some growth, and a repricing closer to NAV, we would expect to roughly double your money over the next 5 years.

W. P. Carey Inc. ( WPC )

W. P. Carey is one of the highest-quality net lease REITs in the world:

• It has a multi-decade track record of significant market outperformance.
• It has a strong investment grade rate balance sheet.
• It owns a portfolio of mostly industrial net lease properties.
• It pioneered the sale and leaseback model, allowing it to pick up assets with unusually strong lease terms.
• Its leases include CPI rent adjustments which has led to rapid rent growth in recent years.

But despite this, its stock has dropped significantly over the past 2 years and its valuation is now historically low, trading at just 12x FFO and an estimated 25% discount to its NAV.

I think that this is mainly because of WPC's recent decision to spin off its office buildings into a separate REIT called Net Lease Office Properties ( NLOP ).

This deal has pros and cons.

The pros are that:

• It will allow it to rapidly exit its office investments, which are today hurting its market sentiment and reducing its valuation, despite only being a minority of its assets.

• It will rapidly expand its exposure to industrial properties, reaching nearly 2/3 of its assets post-merger, and the market has been granting much higher valuations to these assets.

The main downside is the following:

• As WPC loses 10% of its assets, it will naturally lose a good chunk of its income and it will use this opportunity to right-size its dividend to a lower level in order to be in a better position to self-fund its future growth. This is disappointing for many, because it will break a multi-decade track record of steady dividend payments.

Overall, the deal is neutral in that you are not losing any assets. You still own the office properties via the shares of the other REIT, and the dividend policy is just a capital allocation decision that has no impact on the value of the underlying assets.

Even then, most investors appear to hate this deal and it will likely lead to more volatility in the near term.

But let's now go 5 years into the future.

WPC will likely be an even higher-quality net lease REIT with no office exposure, mostly industrial properties, a lower payout ratio, and a faster growth rate thanks to its ability to self-fund its growth.

Will the market then reward it with a higher valuation multiple than today?

I believe so.

Today, it is priced at just 13x FFO even as most industrial REITs trade at nearly double that.

The dividend news will hurt its market sentiment in the near term as dividend-oriented investors decide to sell the stock, irrespective of its fundamentals, but these investors will be replaced with others who are more total-return-oriented.

Agree Realty ( ADC ) also cut its dividend in 2011 and ruined its dividend track record in the process, but it did not prevent it from later earning the highest multiple in the net lease sector. The market cares about the dividend, but REITs are not bonds and most investors care even more about total return prospects, which will likely improve thanks to this transaction.

It is easy for us to criticize looking from the outside and say that the management shouldn't have sold the office buildings, but we don't have all the information that they have, and their track record speaks for itself.

If they want to get out of these assets fast, then it is probably the right move.

If anything, this simply says that the prospects of single-tenant office buildings are likely even worse than what most may have thought. I have long warned about these assets and my sentiment towards them remains just as negative. Here is what I wrote about Orion Office REIT ( ONL ) back when it traded at a >2x higher share price:

"I think that single-tenant office buildings are potentially the worst possible properties to own today, and this is why Realty Income wanted to get rid of them.

They are fine investments as long as the lease has years on them, but as soon as your lease expires, they can become very problematic because they are very costly and difficult to re-lease. Typically, they require substantial capex investments and tenant improvements, and even then, they may be difficult to re-lease. Since tenants know this, they are in a strong position to negotiate lower rents on a now older building and expensive tenant improvement packages."

I learned this lesson during my private equity days when we couldn't find tenants for some of our single-tenant office net lease investments and they essentially turned into liabilities that were losing money every month.

So I am disappointed to see WPC get rid of these assets as fast possible?

I am not. If anything, I think that they should have bitten the bullet earlier just like Realty Income ( O ). But it won't matter much over the long run, and the market is a forward, not a backward-looking machine.

As it gradually becomes a quasi-industrial REIT and its growth rate accelerates thanks to its ability to self-fund its growth, I expect WPC to eventually reprice at closer to 18x FFO, and that would unlock about 50% upside from here. While you wait, you also earn a 5.5% dividend yield.

Final Note

CPT and WPC are two great examples of blue-chip REITs that are heavily discounted due to temporary challenges. They are the exact type of REITs that I am buying today, because I expect them to gain substantial value over the coming years.

For further details see: