KBWY - KBWY: High Concentration In Overleveraged Small-Cap REITs At The Wrong Time

2023-06-23 18:15:06 ET

Summary

• Invesco KBW Premium Yield Equity REIT ETF has underperformed the S&P 500 by 6.6% since April 4, 2023, when I issued a sell recommendation.
• KBWY's high exposure to abnormally high-yielding REITs increases the risk of falling into a value trap given that there is no focus given to the fundamental analysis.
• The ETF's top holdings are placed in sectors, which experience notable headwinds and have extreme debt ratios making it an unfavorable investment option.
• I am downgrading KBWY from sell to strong sell.

On April 4, 2023, I issued an article on the Invesco KBW Premium Yield Equity REIT ETF ( KBWY ) - KBWY: Bad Choice During Times Of Distress - elaborating on why KBWY provides unfavourable return prospects due to negative macroeconomic and sector-specific backdrop.

Since then KBWY has underperformed the S&P 500 by ~6.6%.

Now the questions is whether KBWY is still a sell or whether the recent divergence in the performance (versus the market) has lead to a more favourable outlook for KBWY's stock.

Synthesis of KBWY's exposures

Currently, KBWY offers an attractive monthly dividend yield of 9% and trades very close to a 52-week low.

More than 98% of the investments are concentrated in the small cap space and distributed among the following sectors:

Four largest sector exposures in the KBWY's portfolio are health care (20%), office (19%), specialized REITs (15%), and diversified REITs (14%).

Theoretically, only office sector seems to impose significant headwinds for KBWY's performance going forward.

However, the mathematics of how KBWY allocates capital among the underlying constituents (i.e., REITs) in these sectors introduce rather risky conditions in the portfolio. Put differently, KBWY invests based on a dividend yield weighted index principle in which the capital gets allocated more to higher yielding stocks and less to lower yielding stocks.

As we know, an exposure towards abnormally high yielding assets typically increases the probability of suffering form a "value trap" and being subject to elevated financial risk.

Let's take a look at Top 3 largest holdings.

1. 7.5% weight for Brandywine Realty Trust ( BDN ) - dividend yield of 17.1%, extreme debt ratio of 72%, which is significantly above the office REIT sector average.
2. 7.4% weight for Hudson Pacific Properties ( HPP ) - dividend yield of 10.3% despite the recent cut of 50% and even more aggressive debt ratio of 83%.
3. 6.4% weight for Uniti Group ( UNIT ) - dividend yield of 13.6% and the second highest debt ratio in the infrastructure REIT segment (86.8% for UNIT versus 58.6% for sector average)

Majority of the remaining holdings carry similar characteristics to the aforementioned stocks, i.e.:

• Sky-high dividend yields sending a clear signal that the market has been assigning considerable risk premiums.
• Heavily indebted balance sheets at levels, which imply a notable risk of distress (e.g., failure to refinance maturing debt, suffering from surging cost of financing due to elevated credit risk premiums etc.).

Three reasons to stay away from KBWY

In my recent article - Buy Office If You Missed Mall And Hotel Renaissance - I outlined several table stakes, which have to be in place for REITs to survive turbulent times when lenders are reluctant to lend and the medium-term supply / demand dynamics do not bode well for top-line performance.

The most important element is the notion of having large cap status and fortress balance sheets. Looking at REIT survivors from mall, retail and hotel crises that have successfully recovered without any equity dilutions, it is clear how the investment graded balance sheets and large capitalizations factors played a vital role.

This is crucial to access capital from diversified sources as it allows REITs to enjoy an access to financing at favourable terms and at the necessary scale to avoid any refinancing risk.

Back in the Covid -19 era and initial work-from-home crisis, REITs, which had overleveraged balance sheets and relatively minor capitalization levels, were forced to either file for Chapter 11 or massively dilute the existing shareholder base.

For example, Washington Prime Group Inc, Pennsylvania Real Estate Investment Trust ( PRET ) and CBL & Associates Properties, Inc. ( CBL ) filed for Chapter 11. Macerich ( MAC ) was forced to significantly dilute its shareholder base to survive. Currently, Ashford Hospitality ( AHT ) is also one step away from bankruptcy.

So, the first reason to avoid KBWY is the fact that it tracks only small-cap REITs, where the lion's share of them carry significantly leveraged balance sheets.

Furthermore, whenever stocks offers abnormally high dividend yields, there is an increased risk of falling into a value trap. In fact, looking at the Top 10 largest holdings, 4 have already cut their dividend this year.

It is highly likely that there will be more dividend cuts taking place within KBWY's portfolio over the foreseeable future. Again, this is only logical considering the mechanics how KBWY selects and distributes its capital among U.S. equity REITs. During times of distress the strategy to invest into highest yielding REITs without a robust analysis on the underlying fundamentals is a recipe for disaster.

It is inevitable that a major chunk of these high yielding REITs will have to decrease their dividends to avoid further weakening of their balance sheets. However, in the context of times like these when lending conditions are tight and interest rates are much higher compared to a period when the existing borrowings were assumed, smaller dividends are not sufficient to move the needle.

All in all, the second reason why investors should consider avoiding KBWY is the notion of value trap and seemingly attractive yields (and valuations), while in reality they are fully justified given the weak balance sheets and deteriorating cash flows.

Finally, in the times of uncertainty when the outlook on the economy, interest rates and supply / demand balance is negative, it is the right moment to become a selective stock picker.

The two largest sector exposures (office and health care) of KBWY's portfolio, suffer from major headwinds - e.g., work from home dynamics, maturing debt, which nobody is willing to refinance, inflationary factors, difficulties to find a workforce at reasonable wages and surging interest rates. While there is an overall distress in the office and health care sectors, there are also attractive opportunities to be found.

If you invest blindly into this space with a focus on the highest yielding stocks, which per definition implies a focus on the most distressed REITs, you automatically subscribe to a huge risk of experiencing permanent losses of capital. This usually takes place via bankruptcies, restructuring or massive equity dilutions, where the chances of recovering initial investments are very low or extremely distant in the future.

So, the third and final reason to not invest in KBWY is the opportunity cost factor. Namely, at the KBWY's currently offered yield level of 9%, there are better high yielding opportunities out there that come with a more balanced risk profile and less leverage. For instance:

• Global Medical REIT Inc. ( GMRE ) yielding 8.9% and having a well-structured balance sheet.
• Simon Property Group, Inc. ( SPG ) yielding 6.7%, which is slightly lower what KBWY offers in yield, but at far greater capital appreciation potential and minimal financial risk due to investment grade balance sheet.

Justification for downgrading KBWY to strong sell

Since April 4, 2023, when I issued a sell rating on KBWY, several things have changed making the ETF even less attractive and risky.

The composition of Top 10 holdings has become more concentrated and more exposed towards equity REITs with weak and deteriorating fundamentals.

Back in April, the Top 10 holdings accounted for ~42% of the total portfolio, whereas now the largest 10 allocations of KBWY constitute ~51% of the total portfolio value. This means that the concentration risk has increased, and, unfortunately, right into the highest yielding instruments due to the previously described allocation mechanism.

Furthermore, KBWY inherently carries significant exposure to indirect leverage (i.e., via underlying investments, which in turn are massively leveraged), which has become a higher concern due to the recent commentary by the FED. Currently, the market is pricing in a notable probability of experiencing an additional rate hike of 25 basis points in September. The combination of higher rates and more realistic 'higher-for-longer' scenario should put a strong downward pressure on KBWY's ability to protect its value going forward.

Each incremental uptick in cost of financing magnifies the already aggressive risk factors stemming from KBWY's indebted allocations, ultimately increasing the probability of suffering from dividend cuts and equity dilutions.

As elaborated above, this is what we already have started to witness among several KBWY' holdings, where highly leveraged REITs with aggressive FFO payout ratios have revisited their distribution policies. We have not yet seen these small-cap equity REITs going belly up, but given that the rates have gone up and most probably will continue to trend upwards, we should see some of the KBWY's investment filing for Chapter 11.

Risks and final conclusion

Obviously, shorting KBWY comes with its risk as well. The key risk for any investor, who has decided to open up a short position in KBWY is the FED and its actions on the interest rates. An unexpected pause or a sudden shift in the overall policy from hawkish to dovish could provide a massive boost for KBWY's stock price. Under lower interest rate environment, the highly leveraged REITs would face more favourable financing conditions, where each refinancing event provides an opportunity to strengthen the cash flows due to reduced borrowing costs (opposite to what we have now).

Another risk factor is the M&A aspect, where these small-cap, highly leveraged and depressed REITs are increasingly getting more attractive as targets for large cap players with investment grade balance sheets. For example, if even two names from the Top 10 holding list were taken over, the chances are extremely high that KBWY's stock would react in a very positive manner, thus inflicting a damage on the short position.

With that being said, I strongly doubt that any of the aforementioned risk factors will materialize in the foreseeable future given that the FED is contemplating on how to hike and not how to potentially cut.

In a nutshell, KBWY is a subpar investment for investors, who seek to capture juicy yield with relative stability in the future. The inherent financial risk and opportunity cost offsets the benefit of the currently offered dividend yield by KBWY. Taking short position in KBWY should provide, in my humble opinion, solid returns in the next 3 - 12 month period.

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