VONOY - Important Warning To REIT Investors

Summary

• REITs are trading at the lowest valuation in years.
• Yet, few seem to be buying them due to fears of rising rates.
• We think that the fears are unwarranted and explain why that is.

Every crisis we have is always the worst crisis we've ever had. If you have a long term plan, these things come and go. You can capitalize on these situations ." - Bruce Flatt, CEO of Brookfield ( BAM ), September, 2022

Remember when even high-quality REITs traded at a steep discount to NAV and offered high dividend yields in early 2020? Temporarily, you could have bought blue-chip REITs like Federal Realty ( FRT ), Prologis ( PLD ), and Welltower ( WELL ) at just 60 or 70 cents on the dollar.

Well, if you missed those bargains, you are now essentially given a second chance.

The market was already down heavily as we entered September and it then proceeded to dip even further:

REITs are down 34% on average and a number of smaller and lesser-known REITs are down closer to 40% or even 50%.

As a result, we now have some very "respectable" REITs like Armada Hoffler ( AHH ), Simon ( SPG ), and EPR ( EPR ) that trade at ~40% discounts to NAV and offer 7-9% dividend yields.

Then there are also a number of "blue-chip" growth REITs like Federal Realty and Welltower that now trade at ~20-30% discounts to NAV and offer 4-5% dividend yields, up from just 2-3% earlier this year.

You may think that this steep decline is justified because of the recent surge in interest rates, but I am here to warn you: it really isn't and we think that this is a historic buying opportunity.

Here are 5 reasons why:

Reason #1: REITs use little debt in most cases

The average LTV is today the lowest ever at just 35% in the REIT sector. The average private equity investor uses closer to 60%, which is more concerning of course, but REITs have been more conservative since the great financial crisis and this appears to have been overlooked.

Reason #2: Most REIT debt is fixed rate and enjoys long maturities

Therefore, the impact on the profitability of REITs is often immaterial. Only a small amount of debt is directly affected. Most REITs just need to refinance 10-20% of their debt each year. By the time most of this debt is refinanced, inflation will likely be much lower and the interest rate environment will also likely be more favorable.

Reason #3: Interest rates are rising because of inflation, and inflation benefits REITs

It makes new properties a lot more expensive to build and allows existing properties to hike rents as their replacement value grows. Moreover, it also permanently reduces the real value of their debt, which is essentially a gift to anyone who holds long-term fixed-rate debt.

Reason #4: Higher interest rates also benefit REITs indirectly because it makes real estate ownership a more costly alternative for tenants

Tenants need to always consider the pros and cons of renting vs. owning. As owning becomes more expensive due to rising interest rates, renting becomes more affordable relatively speaking, and it allows landlords to push for larger rent hikes.

Reason #5: The hawkish Fed stance won't last forever

Right now, the Fed must aggressively hike rates to bring inflation back under control. But as this happens, the Fed will also take a different stance. We are already nearing a recession, which is typically followed by rate cuts. The central bank of England was the first one to give up as it recently shifted back to QE to support its economy. How long before other central banks follow? It is hard to say, but as we go into a recession, supply chain issues are resolved, and the deflationary forces take over, the Fed will also ultimately change its stance. Will this be in 6 months? 12 months? or 2 years? It is hard to say, but it will likely happen. Investors are quick to extrapolate recent events far into the future, but more than likely, rate hikes will again turn into rate cuts faster than many expect. REITs have long debt maturities and resilient fundamentals which means that time is on their side.

So to put it simply: The rate hikes affect only ~35% of the balance sheet (the debt side), but inflation affects 100% of the balance sheet (the asset side). Therefore, you would expect the positive impact of inflation to outweigh the negative impact of rising interest rates in most cases. This is particularly true given how REITs have structured their debt (fixed rate and long, well-laddered maturities).

But of course, this is not always the case, and some REITs will inevitably suffer some pain from the rising interest rates and a coming recession.

Then the question becomes: how much should these REITs have dropped? And secondly, how long will it likely take for their businesses to recover?

Just because a REIT will suffer some pain does not mean that you shouldn't buy it. To give you an example, the fundamental pain may justify a 20% drop in its share price, but it may have already crashed by 50%. The excessive drop makes it a buying opportunity and we have seen many such cases in recent weeks. Perhaps a good example of this would be Global Medical REIT ( GMRE ). It is down 60% year-to-date, but in reality, its long-term fair value has not changed nearly that much. As a result, it is now priced at just 8x FFO and it pays an 11% dividend yield:

Our job at High Yield Landlord is to attempt to cherry-pick the best opportunities in terms of risk-to-reward for more aggressive investors (Core Portfolio) as well as more conservative ones (Retirement Portfolio).

The former portfolio includes more REITs like GMRE that will experience a bit more pain but are so heavily discounted that their upside potential and dividend yields are magnified. The latter one is more heavily oriented towards blue-chip, investment-grade rated REITs that are expected to keep growing fairly consistently, no matter what.

But regardless of which portfolio you decide to follow, I really don't see a need to lose sleep over the recent events. Yes, prices are down heavily, but most of this is way overdone from the perspective of a long-term investor. Fundamentals remain solid, the impact of rising rates is not significant in most cases, and yet, valuations are exceptionally low, resulting in some of the best buying opportunities we've seen in years.

To make my point, consider that Vonovia (VNA / OTCPK:VONOY ), the biggest apartment landlord in Germany, is now priced at just 1/3 of the value of its properties. Its rents are rising some of the fastest in years (helped by inflation) and it has a BBB-rated investment grade balance sheet. Even if you expected property prices to drop substantially, VNA would still be discounted. But how much can property prices really drop? Rents are rising rapidly, a lot more apartments are needed, and its properties are already valued at a large discount to replacement cost on its balance sheet... I would argue that despite high near-term volatility, the long-term value of this real estate is largely unchanged, and even if it dips temporarily, it will inevitably recover. This means that the shares have the potential to double or even triple in the coming years and you earn an 8% dividend yield while you wait. Do I need to remind you that this is a blue-chip, apartment REIT in the leading economy of Europe, which has historically been perceived as a safe-haven?

I am grateful to be able to accumulate more of these shares while they are temporarily discounted. In a way, buying shares of Vonovia feels similar to buying real estate in the years following the great financial crisis. There is high uncertainty. It feels wrong. But this is also why prices are so incredibly low.

So to recap, my main message here is that opportunities are today abundant and the time to be greedy is when others are fearful.

This is not our first rodeo. We have gone through many similar market crashes in the past and we have always, without exception, emerged richer on the other side after we accumulated more real estate at discounted prices.

We don't think that this time will be any different, and therefore, we will continue to make small weekly additions to some of our most discounted holdings.

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