VNQ - Sell These 3 Overhyped REITs

Summary

• I am very bullish on REITs, but not all of them.
• Some REITs are still overpriced, poorly managed, and/or own challenged properties.
• I highlight 3 overhyped REITs that I would sell.

Generally speaking, I am very bullish on real estate investment trusts ("REITs") ( VNQ ).

They are today priced at historically low valuations due to fears of rising interest rates.

But REIT balance sheets are actually the strongest they have ever been, REIT cash flows keep on rising, and dividends keep getting hiked.

Besides, the surge in interest rates only happened because of the high inflation, but as we now get the inflation back under control, we can also expect interest rates to eventually return to lower levels.

This will leave REITs with record-high cash flows and likely push their valuations to new all-time highs.

As REITs recover, I expect some of them to rise by over 50%, and you earn a 5-7% dividend yield while you wait. I love the risk-to-reward at these valuations:

But this does not mean that all REITs are worth buying.

There are over 200 of them, and some REITs remain overpriced, others are overleveraged, poorly managed, and/or invest in challenged property sectors.

At High Yield Landlord, we are very selective and only invest in what we believe to be the top 5% of the REIT sector in terms of risk-to-reward. As a result, we actually stay away from most REITs. In today's article, we will highlight 3 popular REITs that we would consider selling if we owned them:

Iron Mountain Incorporated ( IRM )

IRM used to be a battleground stock, with shorts arguing that its paper storage business will face a secular decline, and bulls arguing that paper storage is here to stay and that IRM would rapidly diversify into data centers.

We think that the truth is likely somewhere in the middle.

Paper storage is not going anywhere anytime soon, but it clearly isn't a growth sector, either. Many organizations still need to store paper documents to comply with regulations, but at the same time, increasingly many businesses are moving to digital and storing a lot fewer documents than in the past.

I run a small business with a few employees and I store 90% fewer documents today than I did just 5 years ago.

Therefore, it is likely that this sector will eventually start to experience declining organic growth. The decline will likely be slow, but even a negative 1% same property growth rate could very negatively impact IRM's fundamentals and market sentiment.

Remember that paper storage remains its main business.

Its data center ventures have been successful, but they remain small and will take a lot of time to grow in size. Despite that, IRM is already priced at a comparable valuation to other data center REITs like Digital Realty Trust, Inc. ( DLR ), and this makes little sense in my opinion.

We think that IRM should be priced at a large discount given that the long-term growth prospects of its main business are highly uncertain at best and very unattractive at worst.

We think that a fair multiple for the REIT would be 12x FFO, which implies that there is 30% downside from here.

Public Storage ( PSA )

PSA recently made headlines as it attempted to buy out its close peer, Life Storage, Inc. ( LSI ), and it also hiked its dividend by 50%.

I view both of these as red flags because it signals that the company's growth prospects are slowing down.

On one hand, the substantial dividend hike signals a shift in their capital allocation policy. It shows that they now have fewer external growth opportunities, so they are bumping up their dividend to return more capital to shareholders.

On the other hand, the acquisition attempt also shows that they are having a hard time finding enough external growth opportunities and so they are turning to buyouts to make up for that. PSA is massive with its $52 billion market cap, and so it needs to find a huge volume of acquisition opportunities to really move the needle.

And unfortunately for PSA, this is happening right as their internal growth prospects are also expected to decelerate going forward.

The pandemic benefited self storage REITs as it greatly boosted demand. Suddenly people wanted to make space for a home office, lots of people were moving around, and many older people passed away from covid.

This temporarily increased the demand for self storage and it allowed these REITs to significantly bump up their rental and occupancy rates.

But now things have begun to return to normal, and I fear that some of the recent gains will prove to not be sustainable.

Disappointing external growth coupled with negative organic growth could lead to lots of pain for PSA and other self storage REITs. And yet, despite that, PSA is today priced at 18x FFO, which is not reflective of this poor growth outlook. We think that as its FFO declines and its multiple compresses, PSA could still suffer 10-20% downside from here.

Tanger Factory Outlet Centers, Inc. ( SKT )

On the surface, SKT may seem very attractive.

It is a high-quality REIT with a good balance sheet , strong management, and it trades at just 10.5x FFO, which is low relative to the company's recent growth.

But here is the main issue:

SKT specializes in outlet centers and, as I have explained in a separate article , I fear that outlet centers will face lots of challenges in the years ahead. I think that it is the worst segment of the retail REIT market because:

• Properties are typically located in more remote locations, outside of cities.
• They heavily focus on discount fashion.
• Property layouts are difficult to adapt to the changing world.

As such, I think that they will be the most affected by the growth of same-day delivery and the rise of chains like TJ Maxx ( TJX ). It will be harder to justify a 30-minute drive to get to an outlet when you can now order the same product at a similar or better price online and receive it the same day and/or go to a TJ Maxx, likely in a more convenient location.

Class A malls are better prepared to face these challenges because they are typically in great locations and their layouts are more flexible, allowing them to diversify away from fashion and become mixed-use destinations.

Despite that, SKT is today priced at a comparable valuation as Class A mall REIT Simon Property Group ( SPG ). If I owned SKT, I would sell it and reinvest in SPG if I wanted to invest in retail real estate.

Bottom Line

You need to be selective when investing in REITs.

Not all of them are worth buying.

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