REG - 2024 Analyst Outlook: Brad Thomas On REIT Sector Opportunities And Market Expectations

2023-12-19 08:00:00 ET

Summary

• After a challenging few years, REITs may be in a unique position to deliver for investors.
• But it’s crucial to be selective. Scale and cost of capital advantages that allow REITs to increase market share and continue to grow earnings and dividends are important factors.
• Careful consideration of the different types of REITs worthy of investment should be part of an investment assessment.
• REIT expert and Investing Group leader Brad Thomas shares his outlook for the sector, along with his analysis of different REIT sectors and M&A activity.

REIT investors faced a challenging year, with the sector underperforming other parts of the market.

But that could change in 2024, according to Seeking Alpha analyst and Investing Group leader Brad Thomas.

Today, most REITs are well positioned to grow their businesses (and grow earnings and dividends). Scale and cost of capital advantages have set up the best-managed REITs for long-term success, Thomas says.

How should investors assess REITs heading into the new year? It's important for investors to review each REIT sector carefully for opportunities. Also, M&A activity may be a key story for the REIT sector in 2024.

Thomas also shares his bigger market outlook in this Q&A Outlook piece:

Seeking Alpha: 2023 has been a challenging year for REITs. Interest rate increases, tightening in bank lending, and some defaults have hurt the asset class. What do you see for 2024?

Brad Thomas : Let's first distinguish what REITs do and how they're structured.

As I wrote in my new book, "all of the property in the world is worth an estimated $228 trillion. No other asset class comes even close to matching real estate in this regard, much less beating it."

Yet global REITs represent around $3.2 trillion of that, which gives you some idea as to how fragmented the REIT landscape is today.

There are hundreds of REITs out there with a broad range of property sectors. And each one behaves differently. So the challenges you cite (i.e. rate increases, loan defaults, etc.) may or may not be as impactful depending on the category's underlying fundamentals.

For example, certain sectors like self-storage and hotels have superior pricing power, which means they're able to increase rental rates quicker in response to rising rates.

Conversely, other sectors like net-lease or industrial REITs, aren't able to increase rents as quickly because the leases are longer duration.

With that said, it's true that all REITs have had to adjust to accelerated cost of capital, which has made 2023 challenging.

Challenging, but not devastating. That's because "most" REITs were in healthy financial condition before 2023.

It's true that leverage increased through the run up to last decade's Global Financial Crisis ("GFC"). And it briefly spiked in 2009 to 64.7% when market values fell.

However, it's stayed below 40% since 2011 and has stabilized in the low- to mid-30% range since 2016. And that's not the only way REITs have lowered their exposure to high interest rates since the end of the GFC. They've also reduced their interest expenses, used fixed-rate debt, and increased the term of that debt.

As of Q3 29023, REIT balance sheets were solid and well positioned for economic and capital market uncertainty. On average, their:

• Leverage ratios remained modest with debt-to-market assets at 36.2%.
• Weighted average term to debt maturity was 6.5 years.
• Weighted average interest rate on total debt was 4.0%.

In short, REITs have a long runway to manage leverage in this higher interest rate environment thanks to fixed-rate debt locking in low interest rates for long terms.

Now, as I mentioned, certain sectors do behave differently. So I'm the first person to acknowledge that there are an increasing number of loan defaults within the office and hotel sectors.

The Mortgage Bankers Association released a survey estimating the maturity profile of all commercial and multifamily mortgages, including those held by banks and non-bank lenders. It calculates that $728 billion, representing 16% of total loans, will mature in 2023, with another $659 billion, or 15%, coming due in 2024.

The hotel/motel category has the largest share of loans maturing in 2023 at 34%, followed by offices at 25%. Multifamily, with 9%, has the smallest share.

While these numbers may be shocking to those listening exclusively to the mainstream financial media, most REITs aren't exposed to the same loan default risks due to the healthy balance sheets I just mentioned.

In fact, the distress in the private real estate markets is good for REITs. It allows them to take advantage of that distress and pick up assets on the cheap.

Many REITs I write about frequently are in a perfect position to capitalize on the opportunities in 2024. Their scale and cost of capital advantages will allow them to increase market share and continue to grow their earnings and dividends.

SA: Obviously not all REITs are equal, and certain types of REITs have performed better than others over the past year. Are certain REIT sectors more attractive than others as we head into the new year?

BT : That's a great question.

Let's acknowledge that, in order to outperform the market, REIT investors must have a grasp on the property sectors they're investing in.

For example, one of the reasons I've avoided the residential mortgage REIT (mREIT) sector is because of its higher-risk attributes in the increased amounts of leverage these companies tend to hold. I prefer to recommend and invest in 1) property sectors that 2) I understand and 3) don't depend on high leverage to generate sustainable profit margins.

Accordingly, I think a good way to think about REITs is to utilize what I refer to as the "anchor and buoy" approach. By this, I mean you weight various property sectors based on your knowledge of them and your own risk tolerance level.

"Anchor" sectors include categories such as:

• Net-lease
• Industrials (logistics)
• Datacenters
• Cell towers
• Residential (apartments, manufactured housing, single-family rentals)
• Self-storage

Whereas "buoy" sectors, which are generally speculative, riskier plays with higher leverage and unproven track records, include categories such as:

• Farming
• Malls
• Shopping centers
• Offices
• Healthcare
• Cannabis

I'll also mention preferreds and commercial mREITs.

As you know, I already pointed out how many well-capitalized REITs are equipped to acquire new assets as the private market deals with loan maturities and banks that are no longer lending. That same factor bodes well for mREITs, since real estate entities will be more likely to turn to them for support.

I like the smaller commercial mREITs, most of which are positioned to become "modern-day banks."

Look for them to continue to grow earnings per share by casting their nets to established private market landlords who need short-term bridge financing.

mREITs and preferreds alike also can offer good yield enhancement, which is why I own percentages of both. My blueprint can look something like this:

• Anchor sectors: 60%
• Buoy sectors: 20%
• Preferreds: 10%
• Commercial mREITs: 10%

Recognizing that a recession may be around the corner, I'm personally avoiding hotels and billboards right now. They typically underperform during economic downturns.

But net-lease looks very appealing going into 2024. As a whole, the sector trades at a 12.3 price-to-fund from operations (P/FFO) with an average dividend yield of around 7%.

Another group I like - which I refer to as the "tech trifecta" - are cell towers, data centers and industrials. Their earnings are indicative of the almost infinite demand for their real estate products. Most are likely to generate high single-digit growth in 2024 and 2025.

The residential sector - which includes apartments, manufactured housing, and single-family rentals - and self-storage also can be solid places to park capital. Rising rates have served as a catalyst for apartment landlords as many potential homeowners have been forced to wait before purchasing a new home.

SA: What should investors look at when assessing REITs? Strong balance sheets? Consistent earnings? Location? Management? Dividend history?

BT : All of the above.

In today's world, information is readily accessible, with Seeking Alpha being one great place to research REITs. Investors can analyze data and read over research from their favorite authors.

As a real estate developer in a prior life, I'm attracted to breaking businesses down from the ground up. I want to see a company with a solid foundation, sustainable business model, and respectable management team.

A few weeks ago, I wrote an article titled " Earnings Determine Market Price in the Long Run ." I explain in it that, "At the heart of my thesis is the reality that the 'stock market' values a business by capitalizing the company's earnings power in the long run."

To put it bluntly, I'm obsessed with earnings because this is the fuel that generates dividends. Without sustainable and growing earnings, a company isn't able to grow its dividends, which means it will most definitely become either a "sucker yield" or "value trap."

Yes, I'm aware of the importance of location. After all, I built stores for well-known brands such as McDonald's, Walmart, Walgreen's, and CVS. However, location is just part of the puzzle. It also takes good management with capital markets discipline to generate sustainable profit margins over time.

All of that - every bit of it - leads back to one thing: Dividends, dividends, dividends.

SA: How about M&A activity in the REIT space?

BT : As I mentioned earlier, the net-lease sector is primed for more M&A activity. So is the shopping center sector.

We already saw these deals made this year:

• Spirit Realty (SRC) and Realty Income (O)
• RPT Realty (RPT) and Kimco Realty (KIM)
• Urstadt Biddle and Regency Centers (REG)

I expect to see more activity in 2024, possibly with these targets:

• Retail Opportunity Investment Corp . (ROIC)
• Whitestone Realty (WSR)
• Phillips Edison (PECO)

We've also seen deals in healthcare like Physicians Realty (DOC) and Healthpeak (PEAK). And I wouldn't be surprised to see Ventas (VTR) or Welltower (WELL) get in the game going forward.

There are only two "pure-play" datacenter REIT landlords left at this point since private equity and cell tower REIT American Tower (AMT) gobbled up CyrusOne, CoreSite, and QTS in the last few years.

Meanwhile, I could maybe see something happen in self-storage. Extra Space (EXR) and Public Storage (PSA) have been actively buying up more assets via M&A. Perhaps National Storage (NSA) becomes a target. And there are a few private REITs that could be snatched up as well.

SA: Looking more generally at the stock market and economic conditions… several expect a recession next year. Volatility may dominate the market. Your market outlook expectations for 2024?

BT : I've written a few articles titled "I'm Rooting for Recession." That may seem inconsiderate, but what I mean is that I'm excited to see rates come down and deals come out.

I've lived through multiple recessions, including the so-called "Great One" that landed me on Seeking Alpha. I lost my job in 2010, so I know what it's like not to have a paycheck. I can tell you it wasn't easy trying to feed a family of seven, so I'll stress again that I'm not hoping anyone loses their employment.

Nonetheless, recessions are inevitable. And it appears that the aggressive rate-hiking efforts by the Federal Reserve are having the intended effect. This dose of "tough love" suggests we're entering either a "soft landing" or perhaps a "garden-style recession."

Either way, the pace of Fed hikes appears to have moderated. So we've likely seen the inflection point. In which case, historically speaking, REITs have returned around 15% during this phase (i.e., in the first six months after the Fed stopped raising rates).

That's why I expect to see REITs rally in 2024. We're already seeing signs of that now, as I posted on X (formerly Twitter) this week.

Once again, property sectors will behave differently, some in a positive way… some not so much. There are definitely certain categories that investors should be cautious of.

But by owning a well-balanced portfolio anchored by stalwart names, you should be able to enhance your returns and live comfortably off predictable and dependable dividends.

Have you ever heard the term SWAN? It stands for sleep well at night, and it can be applied to strong dividend stocks that keep paying out no matter the economic backdrop.

I didn't coin it myself. (I wish I did.) But that's the kind of investment I'm constantly seeking - and finding. And what better way to live a stress-free SWAN retirement than by becoming a virtual landlord and generating returns of 20% per year?

That's precisely what I expect will happen in 2024.

Happy SWAN investing!

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