TJX - Sell Alert: 2 REITs Getting Risky

2023-07-03 08:05:00 ET

Summary

• Not all REITs are worth buying.
• Some REITs are overvalued even after the recent crash.
• We highlight two REITs that we would sell.

Today, real estate investment trusts, or REITs, are priced at their lowest valuations in years.

According to Janus & Henderson, they are now priced at valuations that are reminiscent of the dotcom crash and the great financial crisis.

Valuations are so low because REIT share prices crashed by nearly 30% over the past 18 months even as their cash flows kept rising at a rapid pace:

But just because most REITs are discounted does not mean that all REITs are cheap. On the contrary, quite a few REITs are still overvalued because valuation disparities have grown from one REIT to another.

In what follows, we will highlight two REITs that we once owned but would sell today because they are getting pricey relative to most other REITs.

Iron Mountain Incorporated ( IRM )

IRM is a REIT that owns a portfolio of paper storage facilities, and it is also developing data centers to diversify its business.

Its performance over the last 18 months has been nothing short of spectacular. In hindsight, we have to admit that we sold it too early.

It is one of the few REITs that actually rose in value even as the rest of the sector ( VNQ ) collapsed:

This huge outperformance is even more surprising when you consider the three following factors:

• 1) Higher leverage: IRM has more leverage than average when you adjust for the fact that it does not own many of its buildings. In many cases, it will only own the paper storage racks within the buildings and then rent the building itself on a long-term basis. Adjusted for this, its leverage is slightly above average, which would warrant a steeper selloff than the average of the REIT sector.

• 2) Riskier business: Historically, the market has priced IRM at a relatively low valuation because of its perception that paper storage is a riskier business, especially in today's digital world. Therefore, IRM has commonly also sold off more heavily whenever the market had a "risk-off" moment like it is today.

• 3) Data center risk: Finally, data centers are today out of favor. They are facing declining lease rates because lots of new supply is hitting the market. Moreover, the market has finally come to the realization that data centers are a commodity and the tenants hold a lot of bargaining power. There is also growing risk of obsolescence, with famous short sellers arguing that depreciation is a real expense for data centers, and this has caused the likes of Digital Realty ( DLR ) to collapse.

Therefore, I am struggling to understand why the market is pricing IRM at such a steep premium relative to other REITs. It is today actually priced at a higher valuation than even Digital Realty:

I am in the camp that believes that paper storage is here to stay for a long time to come. However, I also recognize that it isn't a growth sector, and eventually, the organic growth will turn negative, hurting IRM's long-term prospects.

I think that when the organic growth switches from +1% to just -1%, it could have a major impact on IRM's market sentiment because the market is quick to extrapolate recent trends far into the future.

For this reason, I think that IRM offers a relatively poor risk-to-reward prospects at today's valuation.

I still recall pitching it when it traded at less than half of today's valuation, and it was hated back then. Today, it is the opposite and it is getting too much love.

Tanger Factory Outlet Centers, Inc. ( SKT )

SKT is the biggest owner of outlet centers in the U.S.:

I am less pessimistic about SKT than IRM because its valuation is not quite as aggressive.

But here also, I am having a hard time understanding why the market has pushed SKT's share price 15% higher even as the rest of the REIT market dropped by 30%. That's 45% of relative outperformance, which is huge for real estate over such a short time period:

I get it that retail is doing well in the recovery from the pandemic, but Simon Property Group ( SPG ), the biggest mall landlord in the world, has still seen its share price drop by 30% over the same time frame:

This huge difference in performance between SKT and SPG makes little sense in my opinion.

I actually think that SPG's class A malls enjoy better long-term growth prospects because they have become mixed-use destinations and they enjoy better locations with stronger demographics.

Most outlet centers are located a bit outside of big cities, requiring shoppers to drive half an hour to get there, and their layouts also aren't as flexible.

Therefore, I think that the continued growth of Amazon ( AMZN ) and retail concepts like T.J.Maxx ( TJX ) will have a greater negative impact on SKT's outlets than SPG's malls in the long run.

SPG mall:

SKT outlet:

SPG also has a slightly better balance sheet , greater scale, and a stronger track record. With that in mind, I don't understand why the market is pricing SKT at a higher valuation than SPG:

I believe that it should be the opposite. For this reason, I wouldn't buy SKT. My capital is limited and I would much rather own SPG at today's prices.

Bottom Line

I am bullish on most REITs, but not all of them.

I only invest in 1 out of 10 REITs on average and I am so selective because I expect my cherry-picked portfolio to deliver materially higher returns over time.

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