VNQ - Income Growth And Safety - How To Play It Safe And Still Win Big

2023-12-14 07:00:00 ET

Summary

• I built a model portfolio that consists of the highest-quality REITs using our proprietary tracker.
• I want to highlight the safest, highest-quality REITs on the market.
• I also want to show that investors can still outperform the market with safe stocks.
• After all, I always make the case that “the higher the risk, the higher the return” does not always apply to the stock market.

This article was coproduced with Leo Nelissen.

A short while ago, I published my 2024 outlook in a co-produced article with Seeking Alpha.

In that article, I highlighted elevated recession risks and the desperate need to focus on safety.

In general, safety is key. In this environment, it’s even more important!

For example, roughly 40% of Russell 2000 (RTY) companies are losing money. That’s without the impact of a recession…

Here are two quotes from the article (emphasis added):

“When looking for quality, focus on companies with BBB- or better balance sheets . While I like to focus on BBB+ or better, we briefly discussed that everything in the investment-grade range tends to do well, even when things get ugly.”

“Quality is hard to define. I believe quality is a mix of a healthy balance sheet (we just discussed that), positive earnings (do not bet on money-losing corporations), and the ability to grow over time, preferably with secular growth .

When it comes to secular growth, I like companies that benefit from economic re-shoring, healthcare companies, agriculture companies that benefit from an unusually strong replacement cycle, certain real estate firms that come with anti-cyclical demand, and ultra-safe plays in the consumer staples space.”

As we’ll discuss in this article, one does not need to sacrifice returns for the sake of safety.

That’s why I have built a model portfolio of top-tier companies that have both safety and quality that come with income, potential outperforming capital gains, and safety!

Why Safety Is Key

A day after my 2024 outlook dropped, Bloomberg’s John Authers wrote an article on the health of U.S. companies.

According to the article, financial strength among U.S. companies has been on a steady decline, with only a brief interruption following the 2008 Global Financial Crisis.

Analyzing Altman Z-scores, which estimate a company's chances of bankruptcy, reveals a significant drop.

Over the last century, more than half of all public companies appeared financially robust on this metric, but currently, that number has plummeted below 10%!

Essentially, the era of subdued interest rates has given rise to "zombie" companies, unable to generate sufficient profits to cover interest expenses.

Approximately 20% of U.S. firms fall into this category, posing concerns about malinvestment and capital misallocation. Roughly 40% of Russell 2000 companies are in this category, as I briefly showed at the top of this article.

The good news is that corporate treasurers' success in securing long-term debt during the prolonged period of subdued interest rates has played a crucial role in averting bankruptcies.

However, the average length of time left on high-yield bonds has decreased, posing challenges for companies facing higher rates – especially if rates remain elevated.

With all of this in mind, time is running out.

The Fed needs to quickly fight inflation, as it risks doing serious damage to credit quality, although one might suggest that this kind of damage may be needed to combat inflation without risking a second wave of higher prices the moment the Fed takes its foot off the brake.

Either way, I’m increasingly careful when it comes to putting my money to work.

Hence, I built a model portfolio that consists of the highest-quality real estate investment trusts ("REITs") using the iREIT® tracker. I’m doing this for multiple reasons.

• I want to highlight the safest, highest-quality REITs on the market.
• I want to show that investors can build an income portfolio with these companies.
• I also want to show that investors can still outperform the market with safe stocks. After all, I always make the case that “the higher the risk, the higher the return” does not always apply to the stock market.

The Market-Beating REIT Portfolio

Using the iREIT® rating tracker, I found six stocks that have a credit rating of at least BBB+ (which is one step below the A range), a quality score of at least 90, and a valuation score of no less than 50.

Technically speaking, I found seven stocks.

However, one of them is Rexford Industrial Realty ( REXR ). As much as I like this industrial REIT, its stock price history goes back to 2013 only, which would limit my ability to back-test it in a portfolio setting.

The overview below shows the stocks that fit my criteria.

As we can see, we are dealing with a basket of stocks that is overweight residential real estate. That makes sense, as it’s a very safe real estate industry with limited demand risks.

We also see that Realty Income ( O ), the king of triple-net lease retail, is included. The same goes for industrial giant Prologis ( PLD ) and Alexandria Real Estate ( ARE ), which is a healthcare-focused office REIT.

Please note that links to articles are provided when clicking on the name of the REIT in the table below.

(iREIT®.)

The yields of these stocks range from 2.9% to 5.7%, with annual average dividend growth rates between 2.3% and 12.6%.

In other words, investors do not have to give up on yield or growth when it comes to buying safety!

Not only have these REITs survived every major recession of the past few decades, but they have also increasingly improved their balance sheets, which has provided investors with a stellar risk/reward picture.

Going back to 2005, an equal-weight portfolio of these six stocks has returned 8.8% per year, which includes a 62% drawdown during the Great Financial Crisis.

A $10,000 investment would have turned into almost $50,000 without a penny of additional capital.

If investors had invested just $200 per month on top of an initial $10,000 investment, they would have ended up with a final cash balance of almost $180,000! That’s a profit of roughly $130,000 on a total investment of close to $50,000.

It also would have beaten the return of the average REIT.

During this period, the Vanguard Real Estate Index Fund ETF Shares ( VNQ ) returned just 6.4% per year.

Even better, the model portfolio had a standard deviation of 21.8% during this period. That is lower than the 22.3% standard deviation of VNQ.

In other words, risks were lower while returns were higher – all based on just six stocks. Most of them have conservative business models.

Even during the Great Financial Crisis, this portfolio did better, outperforming the VNQ ETF by roughly 630 basis points when it comes to the max drawdown.

Over the past five years, the returns have come a bit closer with a similar volatility profile, which I attribute to the massive surge in REITs after the pandemic.

Going forward, I expect this stock basket to keep outperforming the VNQ ETF, especially if the economy suffers from higher debt/corporate defaults in 2024 and beyond.

It also needs to be said that all REITs on this list are attractively valued.

The total return expectations I’m about to show you are based on the current blended price/AFFO (adjusted funds from operations) ratios, the long-term normalized valuation multiple, and expected AFFO growth rates. All numbers are visible in the overview for each stock.

Essentially, we assume that the stocks will gradually return to their normalized valuation. When we include expected AFFO growth and the dividend, we can estimate a total return.

However, note that these are in no way guaranteed returns.

While we believe that these stocks will reach their fair values over the next few years, it will likely require lower interest rates before investors give REITs significantly higher valuation multiples.

Nonetheless, these numbers give us a great picture of the attractiveness of current valuations.

Prologis has an expected total return of 10% through 2025, mainly because of expected AFFO contraction in both 2023 and 2024. After 2024, the company is expected to see a significant increase in growth.

Camden Property Trust has an implied annual total return of 21%, mainly due to consistent AFFO growth and a steep stock price selloff.

Alexandria Real Estate has a similar annual total return projection of 22% thanks to consistent AFFO growth (no expected contraction) and the fact that its stock price sold off, as investors sold everything related to office real estate.

Again, bear in mind that ARE owns high-tech office buildings and research facilities for biotech and related companies. It has campuses that do not compete with “generic” office real estate.

Realty Income has an implied annual total return of 23%. Realty Income, too, is expected to avoid AFFO contraction. If the company is able to grow AFFO by 3-4% per year, it is significantly undervalued.

Like the aforementioned picks (except for PLD), Essex is expected to also avoid AFFO contraction. A return to its normalized valuation of 22.7x AFFO could pave the road for 20% annual returns over the next few years.

Last but not least, AvalonBay Communities is also projected to return more than 20% on its way to a valuation normalization.

Needless to say, there are also other REITs with defensive business models, healthy balance sheets, and the ability to outperform.

However, in this article, we wanted to emphasize the need for safety, as the economy is not as strong as it may seem, especially with regard to financial default risks.

In light of these developments, focusing on quality does not mean that investors are giving up on potential returns.

On the contrary!

By protecting one’s downside, investors can generate superior returns while enjoying a consistent stream of steadily growing dividends!

Most people think that the higher the risk, the higher the return. While that may be true in certain comparisons (like bonds versus stocks), it does not turn into reality when dealing with single stocks.

The best-performing investments come with some form of downside protection.

Or to put it differently, not getting whacked during recessions is a major step toward long-term wealth building and outperformance.

As a long-only investor, I focus on high-quality stocks with top-tier balance sheets like the stocks in this portfolio.

I have all of them on my radar and look for good deals during corrections.

Going forward, I’ll provide more low-risk, high-return picks across a wide variety of industries that fit my risk profile.

Takeaway

In today's uncertain economic landscape, safety is paramount for investors.

As I emphasized in my recent 2024 outlook, the risks of recession are high, making it crucial to prioritize quality and stability in our portfolios.

To navigate these challenges, I've curated a model portfolio of top-tier REITs using the iREIT® tracker.

These companies boast BBB+ or higher credit ratings, solid business models, decent yields and dividend growth, and proven resilience through past recessions.

Despite the prevailing economic concerns, this portfolio has consistently outperformed, providing not only safety but also impressive returns.

The key takeaway: prioritizing quality doesn't mean sacrificing returns; it's a strategic move toward long-term wealth building and financial outperformance.

For further details see: