VICI - Why REITs Should Pummel Tech Stocks

2023-09-14 08:05:00 ET

Summary

• The market hates REITs.
• But it seems euphoric about tech stocks.
• I explain why this doesn't make much sense.

The investment market is vast and versatile.

It includes countless different asset classes, but your capital is limited.

This forces you to make tough choices:

Do you invest in one asset class or the other?

You could of course invest in all of them, but that would leave you with average returns, which is not what we are seeking here at "Seeking Alpha."

This brings us to real estate investment trusts, or REITs ( VNQ ), and Tech stocks ( QQQ ).

Historically, both have been very popular asset classes among individual investors and rightfully so. They have both been some of the most rewarding asset classes of the entire financial market over the long run:

But today, everyone seems to hate REITs, and investor's allocations to them have dropped to historically low levels not seen since the aftermath of the great financial crisis.

Simultaneously, Tech stocks are getting a lot of love and they are now priced at historically high valuations as a result of significant investor appetite.

But I think that it should be the reverse, and in today's article, I will explain to you why I expect REITs to pummel Tech Stocks in the coming years.

There are three main reasons for this:

Reason #1: Historically Large Valuation Spreads

It is normal for growth stocks to trade at higher valuation multiples.

However, there are times when the spread gets excessive and I believe that this is the case today.

REITs have crashed since the beginning of 2022 and as a result, they are now priced at exceptionally low valuations.

At the same time, Tech stocks have been more or less stable. Some like Amazon ( AMZN ) dropped a bit, but then some others like Nvidia ( NVDA ) surged as if it was the dotcom boom all over again, helping to stabilize the sector averages:

As a result, there is now a wide disparity in valuation multiples between REITs and Tech Stocks:

This makes little sense to me considering the following:

Reason #2: Tech Stocks Are More Exposed to Rising Interest Rates

The reason why REITs are down so much is because a lot of people appear to believe that REITs are more heavily exposed to rising interest rates.

But in reality, this really isn't the case.

REIT balance sheets are today the strongest they have ever been with LTVs as low as 35% on average. Moreover, most of their debt is mostly fixed rate, and maturities are long and well-staggered.

To give you an example, let's assume a REIT has a 30% LTV and a 10-year debt maturity. Assuming these maturities are well-staggered, it would mean that only about 3% of its capital stack needs to be refinanced each year at higher rates. Meanwhile, rents are growing rapidly in many property sectors, and the rent hikes affect 100% of the assets.

This explains why most REITs have kept growing their cash flows and dividends despite the surge in interest rates and the crash in their share prices.

I understand of course that higher interest rates lead to higher discount rates in valuation models, but the same should apply to tech stocks, and in fact, their valuations should suffer a lot more than those of REITs because they don't generate much profit today.

Here you need to understand that a higher discount rate will have a much greater impact on cash flows earned in year 10 than in year 1.

REITs generate a lot of cash flow already today and they are priced at low multiples. Tech stocks, on the other hand, typically aren't earning much profits today, but the market anticipates large profits sometime down the line in the future and this is why it is pricing them at large multiples.

Therefore, the valuations of tech stocks should have been much more negatively affected by the surge in interest rates, but this hasn't been the case.

It seems that the market got a bit overly excited by the "AI" frenzy and forgot about interest rates for a moment. It caused companies like Nvidia to more than triple in value in less than a year even as interest rates surged to much higher levels. But for how much longer will this rally hold?

This brings me to my last point:

Reason #3: REITs Enjoy A Stronger Catalyst

Warren Buffett has taught us to be fearful when others are greedy and greedy when others are fearful. This is simply because the market tends to overreact both ways. It will get overly pessimistic on the downside and way too euphoric on the upside.

With that in mind, it seems quite clear to me that the market is today overly pessimistic about REITs and getting too excited about tech stocks.

As a result, I believe that REITs now offer much better margin of safety and upside potential in the coming years.

They are priced at low multiples and high dividend yields, despite having strong balance sheets and retaining a lot of cash flow to reinvest in growth.

As a result, there are many examples of REITs that are positioned to deliver >10% annual total returns from their yield and growth alone.

To give you an example: VICI Properties ( VICI ) is today priced at a 5% dividend yield and it has guided to grow its FFO per share by 10% this year, resulting in a 15% total return on a constant multiple basis. Its multiple is now just 12.5x, which is also historically low for the REIT, providing margin of safety.

But here's the kicker:

We think that interest rates will return to lower levels in the coming years because the high rates were a temporary solution to a temporary crisis. The inflation has now been brought back under control and as the high rates begin to harm the economy too much, I expect the Fed to cut back - just as they have done every single time over the past 40 years:

And as interest rates eventually return to lower levels, REITs could enjoy significant upside potential because this is the only reason why their valuations are today so heavily discounted.

There are a number of REITs that have seen their share price cut in half over the past year even as their cash flows kept on rising and as a result, they are now heavily discounted and offer 50-100% upside potential as interest rates eventually return to lower levels. Good examples of that would be the blue-chips Crown Castle ( CCI ) and Alexandria Real Estate ( ARE ):

Just returning to halfway of their previous peaks would unlock 50% upside and that would price them at just ~18x FFO, which is still very reasonable for a blue-chip REIT with investment-grade rated balance sheets, Class A assets, and steady growth.

Tech stocks, on the other hand, have already recovered and now trade at large multiples as if interest rates had already dropped. In a weird way, it appears that tech investors are already predicting lower rates but REIT investors have missed the boat and so they remain discounted.

In any case, Tech stocks have already recovered and I believe that it will soon be REIT's turn to profit.

Bottom Line

In short, I believe that the market is overpricing tech stocks and undervaluing REITs. For this reason, I am today heavily investing in REITs even as most other investors hold historically low allocations to them.

You don't need to be a genius to understand that buying good real estate that's conservatively financed at a discounted price should result in strong returns over the long run.

I am not so sure about buying tech stocks at these high multiples in today's high-interest-rate world.

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