CWYUF - 2 REITs To Buy After The Rally

2024-01-11 08:05:00 ET

Summary

• REITs have risen a lot in recent weeks.
• But not all REITs participated in this recent rally.
• Here are two REITs that remain heavily discounted.

Real estate investment trusts, or REITs ( VNQ ), have risen a lot lately, and this has led many of you to ask me...

What are the best REITs to buy today...

...as if it was now too late to invest in REITs following their recent rally:

But the reality is that this recent rally was just the recovery from the dip that occurred in October, and overall, REITs are still down over 25% since the beginning of 2022:

Also, keep in mind that:

• (1) This is just the average of the sector. Many REITs are still down closer to 50% even following the rally.
• (2) And most REITs have created 5-10% of value during this period by growing their cash flows and/or paying off debt.

This is just to show you that valuations remain historically low across the board, and just because REITs have risen a bit lately does not mean that it is too late to invest in them.

On the contrary, it is now becoming increasingly clear that interest rates will likely be cut in the near term, and if that's correct, then this recent rally is likely just a preview of what's to come. Most major banks including Morgan Stanley ( MS ), Goldman Sachs ( GS ), and Bank of America ( BAC ) are now predicting significant rate cuts by mid-2024, and yet, REITs are still heavily discounted.

So we won't stop accumulating REITs. It is rare to get to buy right at the bottom anyway, and looking back 5 years from now, we think that today's prices will still look very cheap.

But don't buy just anything.

There are better and worse opportunities following the recent rally. Some names rose a lot in a very short period, while some other REITs kept stagnating behind.

Today, we are buying more shares of two specific REITs that didn't participate in this recent rally and have become even cheaper relative to other REITs as a result of it.

RioCan REIT ( REI.UN:CA / OTCPK:RIOCF )

Earlier this year, we sold our position in Brixmor Property Group ( BRX ) for a 155.9% total return because it had massively outperformed the rest of the REIT sector, and there wasn't much upside left.

To be fair, service-oriented strip centers such as those owned by Brixmor are today very desirable. They earn defensive cash flow and they enjoy highly predictable growth prospects because their rents have fallen below market levels following the recent period of high inflation. As leases gradually expire, these REITs can push for significant rent hikes, resulting in steady cash flow growth.

The REIT market, of course, likes that because it means that these REITs are not dependent on public markets to achieve their growth. Moreover, leverage is a lot more manageable if your cash flow is growing steadily.

But there is one REIT in this sector that mostly missed out on the recent rally, and it is RioCan Real Estate Investment Trust:

And it is not just the recent rally.

RioCan has massively underperformed its peers like Brixmor ever since the pandemic began. Its share price has dropped by 25% over the past 5 years even as these properties gained substantial value:

As a result, RioCan is today priced at a much lower valuation than its peers:

There appears to be one main reason for this: Brixmor is an American REIT, but RioCan is a Canadian REIT.

American strip center REITs are getting a lot of love today, but for reasons that we ignore, Canadian strip center REITs aren't. They have kept lagging even as their U.S. peers surged to new highs. It is not just RioCan, but also its other Canadian peers like SmartCentres REIT ( SRU.UN:CA ; OTCPK:CWYUF ).

To be fair, RioCan has a bit more leverage than its U.S. peers. Adjusted for its large land bank and development pipeline which isn't generating any cash flow, its debt-to-EBITDA is 7.4x, but that of Brixmor is just 6.1x.

However, RioCan makes up for this weakness by owning better properties that enjoy faster long-term growth prospects. It earns nearly all of its cash flow from highly urban centers that enjoy significant barriers to entry. They are located in cities like Toronto, where there simply isn't much land left to develop, zoning regulations are very tight, and replacement costs are higher than market values, making new development projects a very unlikely proposition.

But within a 5-kilometer radius of its assets, the average population is 260,000 people and it is growing rapidly. Canada is today by far the fastest-growing G7 country, and the growth is even faster in the markets where RioCan's properties are located:

Rapid population growth coupled with little to no new supply bodes very well for RioCan, and this is well reflected in its high 98%+ occupancy rate (vs. 93.9% for Brixmor) and 20%+ releasing spreads on new leases and 10%+ spreads on renewals. Today, the average rent per square foot for new deals is $27.02, which is well above the average net rent for the portfolio of $21.39. So, there is a large mark-to-market opportunity in its portfolio that should result in significant cash flow growth as its leases gradually expire.

This explains why the company still has a strong BBB investment grade rating, despite having a bit more leverage than its U.S. peers.

I would add that the company has a low 60% payout ratio, which allows it to organically reinvest in its growth, and it is today building a lot of condos, which it is selling at large gains to pay off debt. They reaffirmed this on their recent conference call :

"I'll emphasize that the 2,605 condominium and townhouse units we currently have under construction are expected to generate combined sales revenue of over $800 million between now and 2026. These proceeds are earmarked for effective uses, including the repayment of debt."

So the story is simple:

• The dividend yield is nearly 6% and is paid monthly.
• They retain 40% of their cash flow to reinvest in growth.
• They are developing a bunch of assets to create value and deleverage.
• Their portfolio enjoys strong long-term organic growth prospects.
• They are undervalued by about 30% and offer 40-50% upside potential.
• The dividend was hiked by 6% earlier this year and will keep on growing.

The resulting risk-to-reward is very strong, especially following its recent underperformance and for this reason, we doubled down on the shares of the company.

Camden Property Trust ( CPT )

Camden Property Trust is one of the leading apartment REITs, and it has mostly missed out on the recent rally:

As a result, its valuation has only become more attractive, relatively speaking.

I think that it missed out on this recent rally because investors are worried about how the new supply will impact Camden's rent growth in the coming years.

Camden focuses mainly on sunbelt markets, and those are today facing a huge wave of new supply, which will inevitably impact its fundamentals in the near term.

But I think that the market is missing three things here:

• Temporary issue: Firstly, while it is true that Camden will likely suffer in the near term, this is just a temporary issue. The market only cares about the short run and so this has had a big impact on its market sentiment, but this will be forgotten in a year from now. Times of oversupply are commonly followed by times of undersupply as developers get hurt and scale back new projects. This is already happening, and apartment REITs expect their rent growth to accelerate in late 2024 / early 2025.

• Class B focus: Moreover, Camden owns mainly affordable Class B communities. This is important because they are less impacted by the new supply that's hitting the market. They are cheaper, older properties and so they are not directly competing with one another. Other apartment REITs like Mid-America Apartment Communities ( MAA ) that own mostly Class A properties will likely be more heavily impacted. This is already reflected in their recent leasing performance. Camden's rents on new leases were flat in the third quarter, but those of MAA dropped by 2%.

• More than priced in: Camden is today priced at a near 7% implied cap rate, but you would be happy to get a 5-5.5% cap rate in the private market. This means that it is priced at a 30-35% discount to its net asset value. Its funds from operations, or FFO, multiple is also historically low at 13x FFO, and this is mostly because of a temporary issue.

I would add that Camden just recently issued some 10-year unsecured debt at a 4.9% interest rate. This just shows you that even in today's environment, they are still able to access cheap debt thanks to their A-rated balance sheet . So the impact of rising interest rates is not significant, but they are still priced at a 44% lower levels than at their peak even as their rents have also grown significantly since then:

This is one of my favorite opportunities today.

The upside to fair value is about 50%, and while you wait, you earn a 4% dividend yield. The company retains lots of cash flow to reinvest in growth and create value for patient shareholders.

Bottom Line

Opportunities remain abundant even following the recent rally, and we won't stop buying.

It is rare to ever get to buy shares right at the bottom, so that shouldn't be your expectation.

For further details see: