PLD - 3 REITs For Long-Term And Prudent Dividend Investors

2023-10-02 12:08:21 ET

Summary

• REITs in general are less attractive to investors due to high risk-free rates.
• Investors can approach this by either taking on higher risks for higher yields or investing in REITs with robust and growing cash flows.
• Prologis, Realty Income, and Alexandria Real Estate Equities are three specific REITs that offer attractive initial dividend yields and have strong fundamentals for dividend growth.

In this particular environment, where the risk-free rates, depending on the position in the curve, are in the 4.5 - 5.5% territory many REITs look less attractive for investors, who chase yield.

Currently, the spread between aggregate REIT dividend yield and the U.S. 10-year Treasury yield is negative, while the historical average of the

1. leverage profiles, etc. It is the past 3 decades has been positive at 118 basis points.

What this does, is it creates unfavourable conditions for the REITs to deliver streams of current income, which exceed theoretically guaranteed and higher yielding cash flows. When the risk-free rates are high, it becomes much harder to generate attractive returns on a risk-adjusted basis.

There are two ways how REIT investors could approach this.

1. Go up the risk curve . We have to remember that the REIT universe is heterogeneous, where we have mortgage and equity REITs, 10+ sectors, different leverage profiles, etc. It is not that difficult to find REITs, which offer much higher yield than the risk-free rate alternative. So, by assuming higher risks, investors can access REITs with very juicy yields and at the same time capture massive "duration" risk (because of the embedded leverage), where in the case on interest rate normalization, the returns would most likely go up significantly.
2. Combat the negative spread with growth . Unfortunately, risk-free plain vanilla fixed income instruments do not offer growth. The cash flows are stipulated in advance via prospectus and the only way how one could increase the YTM is by reinvesting the coupons, when the value of the bond has significantly declined. Yet, this is still bound by the maturity date and just as well may produce the reverse effect if the bond price has increased. So, the only way how long-term investors could achieve more attractive current income without sacrificing portfolio quality is by opening an exposure towards REITs with robust and growing cash flows, which can support the dividend growth. Ultimately, the increased dividends should gradually close down the existing spread (assuming all other things being equal).

Personally, I have no strong opinion about the future path of interest rates. I know only that the market has been wrong since the moment, when the Fed started to hike. Now, the market is pricing in a gradual normalization of the Fed Funds rate until 2026 (i.e., decreasing interest rates starting from 2024).

Theoretically, this should trigger massive flows towards REITs, which are extremely sensitive to the interest rate risk and have gone down massively due to the leverage issues. Lower interest rates would in most cases make these businesses more viable, leave them with more cash flows for distributions and allow to refinancing the debt maturities at more acceptable yields. So, the approach #1 (going up the risk curve) might seem the right one considering the consensus estimates on the SOFR.

However, given that these projections have been wrong many times and there is, in my opinion, a notable probability of facing higher for longer scenario for many years ahead, I am more in the camp of growing out from the negative spread with solid dividends.

Below I will provide 3 specific REITs, which:

• Offer attractive initial dividend yield so that the entry point is somewhat acceptable for yield-seeking investors.
• Possess strong fundamentals to accommodate dividend growth in a sound manner.
• Carry a solid history of dividend growth and are commonly viewed as predictable dividend stocks.

#1 Realty Income (NYSE: O )

O is one of the few REIT dividend aristocrats, which has delivered consecutive 637 distributions at a CAGR of 4.4% since 1994. There has been no dividend decrease or pause since the IPO. The Company remains committed and focused in keeping the "dividend king" prestige alive, which translates to an inherent interest of securing stable growth in the underlying FFO figure.

Currently, the dividend profile looks solid with the offered yield of ~6.1%, which is already above the T-bill rate. So, by entering O, investors get immediately greater compensation than what is provided by the U.S. risk-free instruments.

A major reason why O yields more than, say, the U.S. T-bill is because of the recent price decline. On a YTD basis, the stock has fallen by ~21% although the FFO generation has remained stable.

Interestingly, the FFO growth estimate of O remains positive and growing until 2026.

The drop is mostly attributable to the strengthening of the higher for longer scenario. We can also see this implicatively via the FFO growth estimates, where 2023 - 2025 is characterized with a 2 - 4% growth followed by a ~7.8% growth in 2026, when the interest rates are set to finally normalize.

The chart above shows the 10-year historical path of O's P/CF multiple. It is clearly depressed and currently at the very bottom. This confirms that the reason why O's dividend is so high is mostly valuation-driven.

Looking deeper at the O's structure, the debt maturity profile also confirms that the cash flows are largely protected from the interest rate dynamics until 2026, which coincides with the assumption of normalized interest rates.

More specifically, the weighted average term to maturity for O's borrowings is 6.7 years. Until 2026 there are no material maturities, which considering a decreased M&A activity by O should be partially paid down by the retained FFO. As I have articulated in my previous analysis , even if O had to reprice all of its existing debt to the prevailing cost of financing (from 3.7% that is in the books to 6.2%, which coincides with the bond YTMs), the FFO will be still sufficient to cover the dividends and have a bit of capital left for reinvestments.

Moreover, O has a nice embedded growth component that should support the future growth of FFO.

It has almost fully occupied portfolio with a weighted average lease term of 9.7 years. This provides stability in the cash flows, which is crucial for a dividend aristocrat to accommodate sustainable growth.

O's history has shown that during re-leasing events, the Company can benefit from positive spreads that contribute to a continued like-for-like NOI growth. Given the inflationary environment, re-leasing at positive spreads is more definitely more possible.

The combination of an A-rate balance sheet, favourable debt maturity profile and 99% occupied portfolio with a positive re-leasing potential on top of the CPI indexation warrant solid long-term cash generation.

All in all, in O's case investors have the opportunity to buy a REIT, which already now yields more than risk-free instruments and at the same time provides a meaningful growth factor with limited risk.

#2 Prologis, Inc. (NYSE: PLD )

PLD is another REIT dividend darling with great history. It has managed to grow its dividend for more than 10 years in a row, and by looking at the fundamentals the long-term dividend growth prospect seems strong.

In contrast to O, PLD does not offer so attractive dividend yield from the start. Currently, it yields 3.1%, which is below the risk-free rate zone.

However, PLD embodies many growth supportive characteristics, which O does not have.

First of all, PLD operates in sector, which enjoys superb tailwinds. There are clear secular forces supporting the demand for logistic real estate with e-commerce being the most obvious one.

PLD's Q2, 2023 occupancy ratio of 97.2% confirms this. Another factor, which serves as a testament of the underlying demand is the like-for-like NOI growth. The historical 5-year CAGR for the like-for-like NOI has been ~11% .

In REIT business it is very unusual to register double-digit organic NOI growth. There might be some one-offs stemming from accretive M&A or high-yielding CapEx spend, but it is difficult to have it on a sustained basis unless the demand for specific types of properties significantly outstrip the supply.

Currently, because of expensive financing the ground for new supply has become rather restrictive. PLD and the asset owners in this sector are clear beneficiaries of this.

The consensus earnings growth estimate also indicates this that over the long run PLD will be able to deliver substantial returns.

For PLD to have the ability to accommodate long-term dividend growth at a relatively fast pace, it is critical to have truly fortress balance sheet.

In my opinion, PLD has one of the strongest balance sheets in the entire REIT universe. It holds A-rated balance sheet with a fixed charge coverage ratio at 10x and net debt to EBITDA of 4.2x.

Now, the best thing about PLD's capital structure is that almost all of the assumed debt is based on fixed interest rates (~93%) with a weighted average cost of financing of 2.9%. To add a cherry on the top, the weighted average remaining term of debt maturities is 9.7 years. Less than 10% of the currently outstanding debt falls due by 2027.

Plus, PLD has a conservative FFO payout ratio of about 62%, which leaves ample capital for new investments without relying too much on incremental external financing, which at these days is rather expensive.

In a nutshell, while PLD does not have that attractive dividend yield from the start, it possesses a plethora of fundamental characteristics, which should warrant a continued dividend growth. The 5-year historical dividend CAGR has been 12.5% and judging from the financials and the consensus earnings growth forecast, PLD is definitely a solid candidate for long-term dividend investors.

#3 Alexandria Real Estate Equities (NYSE: ARE )

ARE is one of the largest publicly traded office REITs. Many investors have recently punished ARE because of the office exposure. As a result, the dividend yield has reached 10-year highs - offering 4.9% of a forward-looking yield. This makes the entry point in ARE not that painful for yield-seeking investors since the spread between the dividend yield and the T-bill rate (just to take the higher yielding one) is around 40 - 50 basis points.

Now, what the market has been mispricing is ARE's risk profile, which is very different from the general office peers.

ARE carries only AAA and / or trophy-like properties, which inherently are placed in structurally high demand locations. Many other office REITs tend to have a mix of A and B class properties.

ARE's tenant mix is unique as the Company mostly focuses on life science and biotech customers offering tailored labs for R&D - again for which the demand is very stable and not impacted by the work from home movement.

We can see this in the numbers below.

The overall occupancy levels of ARE have remained above 90%. The YTD leasing spreads have been registered at a double-digit territory (17.9%), which clearly would not be possible if the demand for the properties was not there. An additional confirmation we can get via the like-for-like NOI data. On a YTD basis, ARE has managed to capture 6.5% of organic NOI growth, which is just 10 basis points below the 10-year average.

In fact, the analysts are also projecting solid FFO growth over the foreseeable future.

The overall thesis of sustainable dividend growth is strengthened with one of the best debt maturity profiles in the REIT space.

ARE has over 13 years of the weighted average remaining term of its existing borrowing with no maturities in 2023 and 2024. The Company has locked in favourable financing at 3.7%, which is protected by almost entirely fixed rate debt. We have to also remember that ARE has A rated balance sheet, which will come in handy in future refinancings by keeping the new cost of financing as low as possible. Finally, when thinking of the future refinancings, we have to take into account that currently ARE distributes ~65% of its FFO. This leaves the Company with a plenty of capital to partially repay the ensuing maturities via internal cash flows.

The long-term investors should feel confident in ARE's ability to accommodate solid dividend growth in the future.

Bottom Line

While it is true that the risk-free instruments have rendered the dividend story of many REITs unattractive, by being selective it is possible to find alternatives, which provide acceptable streams of current income with an attached element of growth.

Investors do not necessarily have to assume a huge amount of incremental risk just to capture positive spread in yields.

By looking deeper into the REIT universe, it is possible to find companies that already from the start can offer greater dividend yields than, say, the income from T-bills. O is a great example, which has a 6.1% dividend and the right fundamentals to keep delivering monthly cash flows even if its entire debt portfolio had to be repriced at market-level financing terms.

In some cases, REIT investors, who seek yield should consider companies that currently yield a bit less than risk-free rates, but that have strong enough growth potential to gradually close the gap from T-bills or Treasury notes.

ARE and PLD are solid examples here that enjoy secular tailwinds on a sector level and in combination with their A-rated balance sheets and conservative FFO payouts have the internal capacity to facilitate long-term dividend growth.

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