PCH - Hot Potatoes: 6 Potentially Overpriced REITs Yielding Less Than 5%

2023-12-01 17:00:00 ET

Summary

• After the brutal sell-off of the last two years, REITs are poised for a surge.
• However, this upswing will not benefit all REITs equally.
• Cautious investors can now get about 5% with little or no risk, so why invest in a security yielding less than 5%, particularly if it has significant downside risk?
• This article identifies 11 REITs that are potentially overvalued by at least 10% while also yielding substantially less than 5%.  Then it takes a closer look at the top 6 on the list.

After the brutal sell-off of the last two years, REITs are poised for a surge . There are dozens of quality REITs whose yields are at or near their all-time highs. Inflation appears to be under control , and nearly down to the Fed target of 2%. Interest rates will probably hold steady or drop in the foreseeable future. However, this upswing will not benefit all REITs equally, and there are some potential land mines in the REIT landscape.

Thanks to the numerous rate increases over the past two years, cautious investors can now get about 5% with little or no risk (and little or no upside). So what reason would you have, to invest in a security paying less than 5%, unless it has significant upside potential in the share price? Wouldn't there be even less reason to invest in one that has significant downside risk?

This is especially true when there are so many REITs yielding more than 5%, with significant upside built into the price. (In a recent article, I highlighted 10 such REITs .)

For the more risk-averse investors, value investors, and retirees who depend on dividend income, this article identifies 11 REITs that are potentially overvalued by at least 10% and yield substantially less than 5%. Then I take a closer look at the top 6 companies on that list.

The List

Here are the 11 REITs that fit the above criteria. In this table, "Premium" is the percent by which the current share price exceeds the merited buy price.

Source: Hoya Capital Income Builder and Seeking Alpha Premium

Next, let's take a closer look at the top 6, focusing only on the problem areas, to understand why they are flagged.

Safehold ( SAFE ) has problem areas in Dividend Safety, Balance Sheet, Valuation, NAV, and Profitability.

Seeking Alpha Premium assigns this company a Dividend Safety grade of F, indicating it is in imminent danger of a dividend cut , which would probably be followed by a swift and significant tumble in share price. This alarming rating is based primarily on the company's indebtedness and FFO/Debt ratios.

Let's take a closer look at the debt picture. SAFE has an exceedingly high Debt Ratio of 65%. (The formula for Debt Ratio is Total Debt divided by Total Assets.) The average Debt Ratio for REITs as a whole is currently just 30%.

Source: Hoya Capital Income Builder

Making matters worse, the company's ability to pay its way out of debt with its earnings is poor, as reflected by a 10.0 Debt/EBITDA ratio, compared to the REIT average of 6.3. SAFE's FFO/share fell this year by almost 70%. Whether it recovers soon enough to preserve the dividend remains to be seen.

As a result of the dive in revenues, the Seeking Alpha Quant Ratings system also sees profitability as a problem for SAFE, assigning a profitability grade of D and a Sell rating.

SAFE is currently priced at a stratospheric 40.0x FFO '23. Meanwhile, the company's share price reflects only a (-2.1)% discount to the estimated NAV, while the average REIT is selling for a discount of (-18.0)%.

Source: Hoya Capital Income Builder

Industrial Logistics (ILPT), which is externally managed by RMR Group, has growth and balance sheet issues. Its FFO per share has collapsed over the past two years, currently standing at about 25% of its 2020 levels.

Source: Hoya Capital Income Builder

As with ILPT, this has led to drastic dividend cuts and balance sheet issues. The quarterly dividend was cut in July 2022, from $0.09 to just $0.01, where it remains today.

Debts have piled up, resulting in a very high Debt Ratio of 60% and Debt/EBITDA of 16.0, abysmal even by Office REIT standards. An alarming 53.0% of the FSP's debt is held at variable rates. Even if the Fed stops raising rates, these variable rate instruments typically carry much higher interest rates than fixed-rate debts.

Source: Hoya Capital Income Builder

Although FSP's Price/FFO and discount to NAV are in line with the beaten-down Office REIT sector, the Seeking Alpha Quant ratings system assigns the company a D- for valuation.

This is based partly on its very low dividend yield, as well as its Price/Cash Flow of 14.48 and its forward Price/AFFO of 48.80, both of which are far above the sector average.

Farmland Partners ( FPI ) is also facing FFO growth, Dividend growth, balance sheet, and valuation issues. Like ILPT and FSP, these begin with a substantial decline in FFO, from $0.43 in 2020 to $0.17 in 2023.

Source: Hoya Capital Income Builder

Although the company's Price/FFO is in line with the Shopping Center REIT sector, shares are selling at a discount to the estimated NAV of only (-2.1)%, which is 1590 basis points more expensive than the average REIT.

Source: Hoya Capital Income Builder

Seeking Alpha Quant Ratings system assigns UE a valuation grade of D+.

The Bottom Line

I am not necessarily advocating a Sell on any of these companies. However, I am advocating a strong note of caution if they are on your watchlist, or if you are long in any of these, with large allocations. There seem to be many better alternatives for your money at the present time. But that's just my opinion.

As always, the opinion that matters most is yours. Because it's your money.

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