SCHH - SCHH: Speculative Buy On Fed Pivot

2023-10-25 04:10:08 ET

Summary

• REITs have seen valuations compress on higher rates and FFO has been pressured on higher debt costs and lower occupancy.
• Consensus points to a 22% potential upside, suggesting analysts are factoring in a rate cut in YE24.
• I think SCHH is a speculative buy, as it requires a decline in Fed rates to regain valuation levels.

Summary

The real estate sector has been damaged by several factors. A: higher interest rates that impact valuations B: lower results due to higher debt costs and C: Lower revenue due to demand dynamics in commercial, office and other uses. This has driven the Schwab U.S. REIT ETF (SCHH) and peers to underperform the S&P 500 (SPX) by a wide margin. However, a bottom-up analysis, using consensus estimates, points to a significant rebound through YE25. This is likely predicated on analyst expectations that peak rates around the corner as well as discounted valuations. Has the sector bottomed or is there more pain to come?

Bottom-Up Analysis

I conducted a series of bottom-up analysis to better gauge the ETFs dynamics and potential. While the SCHH has 125 holding, 55 REITs make up 80% of the portfolio. I gathered consensus estimates for this set of 55 REITS to calculate potential upside, FFO (Funds From Operations) growth, dividend yield, relative valuation and leverage levels.

In the table below I calculated consensus upside potential using analyst price targets. The weighted upside for the ETF looks quite attractive at 22% plus a dividend yield of 4%. The was a bit of a surprise to me given the apparent difficult operating environment that the real estate sector is in.

FFO Growth and Valuation

As many REIT investors are aware, FFO is one the principal financial indicators used to measure the health of a real estate or real asset company. For a good explanation, see the following link . In essence, its cash earnings or cashflow that can be used to payout dividends or reinvest in other assets. The ETFs portfolio has FFO growth of 5% according to consensus estimates. Again, this comes as positive surprise given the higher interest rate environment where debt costs may be squeezing FFO while revenue is pressured via lower occupancy and the inability to increase rents/leases.

Valuation seems high at 14x P/FFO on YE24 estimates given the low growth rate that results in a 2.4x PEG or in this case P/FF vs Growth. However, the market may view this as fair given the more resilient nature of the sector, at least until covid, inflation and higher rates hit the business model. Americold (COLD) is a clear outlier with 19% FFO growth and a 1.2x PEG.

Dividends Growth of 5%

RIETs are required to distribute 90% of earnings in order to qualify for income tax exception. Thus, they generally provide generous dividend yields. However, when risk free rates rise i.e., the US treasuries, the appeal of a REIT declines, much like bonds. Prices fall so that the yields rise, assuming the DPS (dividend per share) is constant. I found that this ETF has a 5% long term DPS growth rate, which is in line with FFO growth. SBA Communications ( SBAC ) and Host Hotels & Resorts (HST) are outliers with over 18% growth.

Total Return Needs Fed Pivot

I calculated total return to YE25 of 36%. I used the consensus price target for YE24 upside and extrapolated the implied P/FFO target multiple to calculate the YE25 price target. The potential upside is far higher for YE24, which suggest that analysts expect the fed to cut rates next year, in my view. This level of price appreciation requires multiple recuperation (or risk-free contraction) to justify. Thus, it looks like this sector is a play on Fed pivot.

Leverage is High

Finally, I looked at the leverage indicators and I calculated that the ETF is 6x ND (net debt) to FFO and 40% ND to Market Cap. While in a low-rate environment this makes plenty of sense, to lever returns, the situation now may lead to some distress as REITs find themselves rolling over debt at far higher rates that impact FFO. While some properties go under water and the lease may not cover debt cost.

Conclusion

The operating environment of many real estate sectors has been complicated by the higher rate scenario and REITs have seen FFO come under pressure while valuations have contracted. This ETF's portfolio, using consensus estimates, requires a decline in Fed rates to regain those valuation levels thus I find SCHH suitable as a speculative buy option.

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