VNQ - Sell Alert: 3 REITs Getting Risky

2023-03-30 08:05:00 ET

Summary

• The REIT sector presents historic buying opportunities.
• But not all REITs are worth buying.
• I present 3 popular REITs that I would sell.

I am very bullish on real estate investment trusts, or REITs ( VNQ ).

I am so bullish, in fact, that I invest about 50% of my portfolio in them:

Their valuations are today the lowest in years... their balance sheets are the strongest they have ever been... and rents are growing rapidly in many property sectors due to high inflation.

But that does not mean that every REIT is worth buying.

There are over 200 of them and we only invest in about ~25 of them. The reason why you need to be so selective when investing in REITs is that many of them are either overleveraged, overvalued, poorly managed, or own troubled properties, resulting in poor risk-to-reward.

In what follows, we will highlight three popular REITs that we wouldn't buy today:

Life Storage, Inc. ( LSI )

LSI made a lot of headlines recently after one of its peers, Public Storage ( PSA ), offered to buy it out. LSI rejected the offer, claiming that it significantly undervalued the company and its future growth prospects.

Then, shortly after, it was reported that another peer, Extra Space Storage Inc. ( EXR ), could be interested enough to make an offer as well.

What's not to like here?

Well... all these talks of a potential buyout have pushed LSI's share price higher and the disparity in performance between LSI and its peers has gotten massive. LSI is up 33% even as most REITs are down in 2023:

Historically, LSI used to trade at the lowest valuation in the self-storage property sector, but today, it is the opposite. Following its recent outperformance, it is now one of the most expensive self-storage REITs:

The market is clearly expecting a buyout here.

But the issue is that this expectation is already heavily priced into the stock.

PSA had offered to buy LSI for $11 billion, but its market cap is currently already $10.7 billion.

Even if PSA or EXR offered a better deal, it likely wouldn't result in a large premium from here. They simply couldn't as the deal wouldn't be accretive to them otherwise.

So the upside is limited, but the potential downside is quite substantial if the talks of a buyout dissipate and the market turns its attention to something else.

LSI is a great REIT, but the valuation is not attractive today.

Pass.

Equinix, Inc. ( EQIX )

EQIX is a similar case of overvaluation.

This is a high-quality data center REIT.

It has a fantastic track record, a strong balance sheet , and good growth prospects...

But the market has gotten ahead of itself. Unlike most REITs that are priced at near 52-week lows, EQIX has strongly recovered over the past 6 months and it is now priced at about 25x funds from operations ("FFO"):

As a result, its valuation is now more than 10 turns higher than the average of the REIT sector. It is also a lot higher than its close peer, Digital Realty ( DLR ), and even higher than that of cell tower REITs, American Tower ( AMT ) and Crown Castle ( CCI ):

I suspect that lots of money was poured into EQIX as a result of the recent AI revolution. Some investors put money directly into Microsoft Corporation (MSFT) and Alphabet/Google ( GOOG ), while others invested instead in infrastructure like data centers.

The thought process is that AI will lead to faster growth in data and more demand for data centers.

As a result, data centers are now seen as desirable assets and the market is rewarding EQIX with a generous valuation.

But I actually dislike data centers because of two key reasons:

(1) The risk of future obsolescence is very high. This is technology after all.

(2) Your biggest clients are big tech companies, and increasingly many of them are deciding to build their own data centers.

As a result, the bargaining power of the landlord is limited and it hurts the organic growth prospects of your properties. Some short sellers, including Chanos, also argue that depreciation is a real expense for data centers unlike for other property types.

Priced at 25x FFO in a high interest rate world, it is hard to see the value here. I would much rather invest in the cell tower REITs at today's prices.

Global Net Lease, Inc. ( GNL )

GNL is not a case of overvaluation.

The shares are cheap, trading at 8x FFO and a 13% dividend yield.

Many individual investors are buying it because of its high yield.

But here are two issues:

For one, in my view the company is poorly managed. The management earns fees that are based on the volume of assets under management and so they keep issuing more shares at dilutive prices to grow the size of the portfolio. I would not buy GNL at any price because of that alone:

But that's not all. GNL also owns a lot of single-tenant office buildings that face very uncertain releasing prospects. I believe that these properties will face very significant capex as leases expire and this will force GNL to cut its dividend again. GNL's current payout ratio is near 100% and it is not sustainable.

Bottom Line

Just because I invest heavily in REITs does not mean that I am bullish on all of them. There are some historic buying opportunities in the REIT sector today, but there are also many names that you should stay away from.

For further details see: