VTR - Sell Alert: 2 REITs Getting Risky

2023-09-20 08:05:00 ET

Summary

• Most REITs are today undervalued.
• But that does not mean that all REITs are worth buying. On the contrary!
• I discuss 2 popular REITs that I would sell today.

Over the past weeks, I have written several articles explaining why I am very bullish on REITs ( VNQ ). In short, following their recent crash, REITs are now priced at their lowest valuations in years and that's despite having the strongest balance sheets in their history and enjoying steady rent growth in most property sectors:

I believe that the market overreacted to rising interest rates and this has resulted in a window of opportunity to buy REITs at heavily discounted prices.

But just because I am bullish on some REITs does not mean that I like all of them. On the contrary, I have sold quite a few REITs over the past year because of a variety of reasons:

• Some are overleveraged.
• Others are poorly managed.
• And a few remain overpriced even after the crash.

The REIT market is vast and versatile, and if you want to reap the full benefits of their ownership, it is very important to be selective.

In what follows, I will highlight two popular REITs that I wouldn't buy today:

Welltower ( WELL )

WELL is the biggest healthcare REIT in the world. It owns a diversified portfolio of senior housing communities, medical office buildings, life science, and skilled nursing facilities.

It is commonly perceived to be a "blue chip" because of its long track record of excellent performance, its strong balance sheet, and its class-A assets.

But here's the issue summarized in one chart:

It has massively outperformed the rest of the REIT sector in the recent past and as a result, its valuation multiple has expanded drastically even as that of other REITs dropped to historically low levels.

WELL deserves to be priced at a premium, but the gap has grown too much:

We can take this a step further and compare WELL's recent performance and valuation to that of its close peer, Ventas ( VTR ). Both are similar large-cap "blue-chip" type healthcare REITs and yet, they have performed very differently in the recent past, resulting in a growing valuation gap that favors VTR:

This recently prompted a famous activist investor called Land & Buildings to point out this recent disparity in performance. They believe that VTR is undervalued relative to WELL and I agree.

But VTR isn't even my top pick for the healthcare sector.

I would much rather buy shares of the life science REIT leader Alexandria Real Estate ( ARE ) at 12.5x FFO than Ventas at 14.5x, let alone Welltower at 24x - and for this reason, I wouldn't buy Welltower today.

The market appears to have gotten overly excited about the short-term prospects and has now already priced in a full recovery of their senior housing business.

It makes the risk-to-reward less compelling relative to some of its peers that are more heavily discounted.

Industrial Logistics Properties Trust ( ILPT )

ILPT is a popular REIT for one reason: it is the cheapest industrial REIT, trading at just 8x FFO.

The industrial property sector has performed really well in recent years because it has enjoyed rapidly growing demand from Amazon-like ( AMZN ) e-commerce companies and it also benefits from the growing trend of onshoring.

As a result, most industrial REITs like Prologis ( PLD ) have been priced at over 20x FFO during most times.

ILPT is the exception, trading at less than half of that, and it has attracted a lot of value investors.

But here's why this is a trap:

The REIT is managed by RMR ( RMR ) which is a notoriously poor manager. They manage several public REITs ( OPI ; DHC ; ILPT ) and each one of them has done very poorly over the long run:

I believe that this is because RMR suffers significant conflicts of interest and has been more focused on growing its own fee income than anything else.

It has consistently made poor choices, including taking on too much leverage, overpaying for deals, and diluting to shareholders by issuing a bunch of equity at discounted prices - just for the sake of growth as this would lead to higher fee income for them.

Therefore, any investment in ILPT would be extremely speculative since it relies on RMR to take care of its management. The properties may be great, but that doesn't matter if RMR ruins it all in the end.

A good recent example is RMR's decision to merge two of its REITs together: Office Properties Income Trust ( OPI ) and Diversified Healthcare Trust (DHC).

I don't think that this merger makes any sense. Both REITs focus on very different property sectors and the REIT market typically punishes REITs that lack specialization by pricing them at a discount.

Not surprisingly, the market hates the deal:

Could RMR try to merge ILPT with OPI or another entity next?

It wouldn't surprise me at all.

Sometimes a low valuation is deserved and this is the case here.

Closing Note

Not all REITs are worth buying.

I invest about 50% of my net worth into a basket of ~25 REITs that I have cherry-picked in this vast universe of over 200 companies. It is by being so selective that I have managed to earn good returns over the long run.

For further details see: