VNQ - One REIT To Sell And One REIT To Buy

2023-08-01 08:05:00 ET

Summary

• Most REITs are today priced at historically low valuations.
• But that does not mean that all REITs are worth buying.
• I highlight one REIT that I would sell and a superior alternative.

Not all REITs ( VNQ ) are created equal.

Some are today priced at exceptionally low valuations and offer significant upside potential in a future recovery.

Others are overleveraged, poorly managed, own challenged properties, are overpriced, and could suffer a lot more downside in the coming years.

For this reason, it is very important to be selective when investing in REITs.

Just because two companies are structured as REITs does not mean that they have anything in common. This is a vast and versatile sector with over 200 companies in the US alone and at any given time, there are good, average, and bad investment opportunities.

That's why we only invest in one out of ten REITs on average:

In what follows, I will give you a good example of this.

I will highlight one REIT that I would sell if I owned it today, and I will then present a much better alternative to consider for your portfolio.

Tanger Factory Outlet Centers ( SKT )

SKT is the only REIT that specializes in the ownership of outlet centers:

Most of you have probably visited one of their outlets to buy some clothes at a discount. They have properties in a lot of big cities:

I think that this is a good REIT overall:

• They have a great management team.
• Their balance sheet is conservative.
• They have a unique strategy that has historically done well.

But there are two main issues:

1. The company's valuation is excessive relative to its peers, especially following its recent surge.
2. Its long-term prospects are questionable, but the market seems to be missing this because it focuses so much on the near term.

Let's start by discussing the outlook for outlet centers.

I am not in the camp that Amazon ( AMZN ) is going to kill everything. I think that there is real value in physical retailing and good outlet centers definitely have a place in the retail ecosystem.

But even then, I recognize that the continued growth of e-commerce will have an impact on various retail properties, and I fear that outlet centers will be some of the most negatively impacted.

This is because:

1. They are typically located in more remote locations where people have to drive to.
2. Moreover, they are near fully focused on fashion and accessories.
3. And finally, their layouts are difficult to adapt to other uses.

So far, they have managed to attract customers by promising them the best prices. People were willing to drive 20-30 minutes to get to an outlet because they thought that this inconvenience would result in savings.

But things have changed.

Now you can get comparable or even better prices online and then in addition to that, discount retailers like T.J. Maxx ( TJX ) have popped up all over the place, often in more convenient locations.

Therefore, I fear that outlet centers will struggle to grow in the long run as they face more and more competition from both, e-commerce and more conveniently located discount retailers.

Simply competing on prices is not enough anymore. Retail properties need to also provide convenience, services, and experiences, and the poorer locations and less flexible layouts of outlets will put them at a disadvantage.

Class A malls, on the other hand, are much better positioned in my opinion because they are typically in prime locations with dense and rich demographics.

Moreover, they are today much better diversified with large service, grocery, experience, and even growing residential components to attract daily traffic.

The retail component is also more resilient because it will typically include a lot of luxury brands like Louis Vuitton ( LVMHF ), which you wouldn't shop online, and the other retailers will also typically use their stores at Class-A malls as last-mile delivery and return centers.

Finally, their layouts are flexible, allowing them to keep adapting over time to the latest needs and desires of consumers.

As such, they don't just compete on prices to get customers in the doors. They pull their traffic by being in superior locations, including non-retail users, and offering a better overall experience.

You can go to a mall to get some work done at WeWork ( WE ). Then you can hit the gym at Equinox before doing some shopping, dining at Cheesecake Factory ( CAKE ), and watching a movie at AMC ( AMC ) or going to the spa and having a drink. You may even Uber ( UBER ) home or even walk home, something you will rarely be able to do from an outlet.

You get the point: class A malls have become mixed-use destinations that are conveniently located, allowing people to meet and serve as town centers.

Therefore, you would expect Class A malls to be priced at materially higher valuations than outlet centers.

But the opposite has happened in the public REIT market.

Today, SKT is priced at 12.5x FFO whereas its Class A mall peer, Simon Property Group ( SPG ), is priced at just 10.5x. Moreover, SPG also offers a materially higher dividend yield:

The difference in valuation is actually even larger when you consider that SKT has a weaker balance sheet than SPG:

It is priced at such a higher valuation because it has massively outperformed over the past year and a half:

We can't find a good explanation for this.

Both REITs are today doing well, but SPG has a better balance sheet and a stronger long-term outlook. Yet, it is priced at a materially lower valuation because it has missed out on the recent recovery.

Therefore, if I owned SKT, I would consider selling. I think that SPG offers far better risk-to-reward at this time and this is where we are investing at High Yield Landlord.

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