2023-10-11 08:52:34 ET
Summary
- Rising interest rates have negatively impacted the economy and the stock market, leading to what we're calling the Great REIT Reset.
- We think that four REITs in particular have been unfairly punished by the market.
- These REITs offer attractive valuations, strong tenant bases, and potential for dividend income.
Background
We don't think it would be a stretch to say that rising interest rates have wreaked havoc on the economy and, at times, different parts of the stock market: 2022 was the time of the great Tech Wreck, when high-flying (often profitless) companies saw the chickens come home to roost as investors woke up to the fact that better returns with comparably less risk could be found. 2023 has been more friendly to the tech sector (at least so far). Another sector, however, has suffered this year in what we're calling the Great REIT Reset.
While charts on most timeframes will show the Real Estate Select Sector SPDR Fund ( XLRE ) keeping pace with the broader S&P 500 ( SPY ), the last year has seen a gulf form between the two indices.
Given the widespread concerns about over-leveraged companies, higher debt costs, and falling vacancies across the commercial real estate sector, this gap makes sense. The market, however, is a blunt instrument that often punishes quality in the same manner as, well... lesser quality.
In this article we'll explore four REITs that we think have been unfairly punished by the market, and which we think are compelling at their current valuation. Let's dive in.
1. Realty Income ( O )
Anyone with an even passing familiarity with Seeking Alpha content knows that a lot ( really, a lot ) of analysts like this particular company. While it may be tempting to find a contrarian view among the rampant optimism, we think that in this case the feeling is justified. Realty Income operates mainly free-standing single-tenant properties, and its tenants are convenience and grocery stores, dollar stores, home improvement chains, and the like.
We recently wrote about Realty Income, and we think the beating the stock has taken in the last two years is largely unwarranted.
Over the past three years Realty Incomes price return has been negative 20%, while the broader market has advanced by 25%. The stock has also fallen by 21% year to date, which is largely due to rising interest rates and fears that all REITs will suffer the consequences equally.
The decline in the stock price has also produced another historic breakdown in Realty Income's price over its GAAP Earnings Per Share [EPS].
Over the last ten years, Realty Income's stock has largely traded along with the trend of its forward GAAP EPS estimates (with the start of the pandemic in 2020 creating the only major aberration). As can be seen in the chart above, however, the stock price has fallen dramatically while GAAP EPS expectations have largely remained flat. According to Seeking Alpha, the stock currently trades hands at 12.4x forward Funds From Operations expectations.
Now, lack of EPS growth is never something investors want to hear about, but interest expense for the company is the largest culprit for said lack of growth. For us, this points to the idea that nothing is fundamentally wrong with Realty Income's business--it is simply being punished for operating in a sector that can be rewarded or punished by changing interest rates.
The company's dividend has reached attractive levels, as well.
Again excluding the anomaly of the pandemic, the current indicated dividend is currently at a ten-year high of 6.12%. Considering the properties in the portfolio and the long-term earning potential of those assets, some investors may find this to be a particularly attractive dividend given that the 10-year treasury currently yields 4.62% .
2. Four Corners Property Trust ( FCPT )
We wrote about Four Corners in February of this year. Since that writing, the stock has unfortunately fallen by almost 20%, but our thinking about the company has not changed.
Born from a Darden Restaurants (DRI) spinoff, Four Corners Property Trust owns the land on which some of the most widely recognized and visited full-service restaurants sit, such as Olive Garden, Cheddar's Scratch Kitchen, and Chili's. The company also has exposure to the auto care and medical space as well.
The stock spent the majority of the last three years treading water until 2023 laid it low--year to date the stock is down 14%.
This underperformance, we think, presents an opportunity given the fact that Four Corner's tenant base is performing well and has many levers to pull to make payments. Since the first quarter of 2020, occupancy has never dropped below 99.6%, and rent collections have never dipped below 99.5% on a quarterly basis.
The stock has also fallen to a three-year low against analyst price targets.
Today's price of roughly $22 sits 23% beneath the midpoint analyst price target of $27.33. Seeking Alpha also shows the stock trading at 13.6x forward Funds From Operations. While this figure is admittedly a premium to the sector, which trades at an average of 11.2x forward P/FFO, we think that the quality of the tenant base makes up for the premium.
Investors seeking dividend income will find something to like as well--the stock has a current indicated dividend yield of 6.14%, which (again, excluding the start of the pandemic) is the highest in the company's history. This dividend reflected a payout of roughly 80% of AFFO.
Four Corner's leverage ratios and debt maturity schedules are some other bright spots. CFO Gerald Morgan spoke to this subject on the company's latest conference call :
With respect to overall leverage, our net debt to adjusted EBITDAre in the second quarter was 5.5x, and our fixed charge coverage was a very healthy 4.8x. Pro forma for the July debt offering, our leverage is approximately 5.8x prior to any third quarter equity activity, which we will announce in our third quarter earnings release in October.
We remain focused on maintaining a conservative balance sheet and extending and layering our debt maturities and repayment obligations. Our only debt maturity before November 2025 and is a $50 million private note due in June of next year.
With the closest debt maturity being more than two years away, combined with a robust tenant base and a strong dividend yield, we think that Four Corners is a REIT that investors shouldn't overlook.
3. American Tower Corporation ( AMT )
American Tower Corporation is the largest cell phone tower REIT in the market, and its stock has been punished dramatically in the last three years, falling by 35% on a price return basis.
The premise of the business is quite simple and (remarkably for a REIT) quite capital light for the company. American Tower owns the land on which the tower goes along with the base of the tower, while the tenants (cell phone service providers) own (so therefore must pay for) the antenna equipment as well as the base stations and shelters on the site.
Unlike other REITs which have largely been punished by the market for their interest rate risk exposure, American Tower has largely been punished by the market due to delayed capital expenditure from cell service providers in the 5G rollout.
CapEx Spend By Wireless Carriers (AMT Investor Presentation)
For context, the rollout of 4G to replace 3G was pricey for cell service providers and a boon for AMT, as average CapEx spend went up from roughly $23 to $29 billion per year. While the rollout of 5G is expected to grow CapEx from $29 billion to $34 billion per year, the spend from cell service providers simply has not yet materialized.
While the CapEx spend has been low, it is not likely to stay low. Service providers cannot delay this spending forever, and 5G will likely soon become the standard consumer expectation. According to a company presentation on U.S. Technology and state of the 5G rollout , the U.S. is expected to have 250 million active 5G subscriptions by the end of 2023, with that figure expected to grow to 410 million in 2028. The company also estimates that fully one-third of all Chinese mobile subscriptions are 5G currently. All of this growth must have accompanying infrastructure, and cell service providers will not be able to forego it indefinitely.
Analysts are also bullish on the company, with the current stock price of $158 sitting a whopping 43% below the average analyst price target of $227. Of the 19 analysts who cover the stock, 7 rate it a strong buy, 9 rate it a buy, and only 3 rate the company a hold.
A spot in which investors may find fault with American Tower, however, is its dividend. With a current indicated yield of 4.09% as of this writing, it yields less than a 10-year treasury note. We think, however, that the anticipated inflow of cash into its business in the form of cell provider CapEx makes the stock worth a close look.
4. Rexford Industrial Realty, Inc ( REXR )
Rexford is an industrial-focused REIT with a geographic concentration in southern California. While more known for Hollywood (or high taxes) than for industrial capacity, southern California is home to the ports of Los Angeles and Long Beach, are far and away the number one and number two largest ports in the United States with a combined estimated 300 million metric revenue tons of cargo coming through each year.
All of that cargo has to go somewhere, and despite the high cost associated with doing business in California, a lot of companies choose to warehouse material in the region.
As with the other REITs in this article, Rexford's stock price largely tracked with the wider market until the start of 2023. From its peak in February of 2023, the stock has fallen almost 30%.
This, to us, seems somewhat unjustified. Consider the 1.9% vacancy rate across industrial properties in the region (on the investor presentation slide, above), and the healthy leasing spreads posted by the company in its latest quarter.
Leasing spread are an indicator of the health of demand, as they represent the difference between new leases signed and old, expiring leases. On a GAAP basis, Rexford saw leasing spreads of 69%. While the company expects a bit of moderation in the back half of 2023 to materialize, the robust spread overall certainly doesn't inspire fear in the hearts of investors. Evidence of strong demand can also be seen in the company's 97.8% occupancy rate, as well as a reduction in average tenant concessions in the third quarter.
Rexford also boasts one of the least-levered balance sheets on our list. The company has a total of $473 million in debt set to come due in 2024, but the company notes that $400 million of this debt has options to extend the maturity if the company so desires. This could help to keep Rexford from refinancing debt at onerous levels, and may allow the company to ride out a substantial portion of the 'higher for longer' interest rate environment we find ourselves in today.
Like Realty Income, Rexford's price has also broken an historical relationship to the company's GAAP EPS.
As EPS has stair-stepped up over the last ten years, the stock price has largely followed suit. 2022 onward, however, has seen a breakdown of this relationship, with the stock price falling even as EPS estimates continued to rise. This, for us, is yet another indicator of a stock that is being punished simply due to the sector it belongs to rather than due to any fundamental business issue.
Investors may not like the fact that Rexford currently has an indicated dividend yield of 3.13%, but we think that given the company's large presence in such a systemically important shipping and warehousing market along with its innate pricing power is justification enough for the dividend to seem attractive at this level.
The Bottom Line
The last two years have seen an unprecedented rise in interest rates, which has Inevitably rippled out into the market. Given the fact that REITs are highly sensitive to interest rates, it only makes sense that the sector would be punished as a whole. However, we think that the particular stocks we've covered here have fundamentals that have remained strong and are worth a close look from investors.
Risks to our thesis include unexpected rate hikes in the future, as well as any material erosion in the resilience of the U.S. consumer, which could lead to a recessionary environment.
For further details see:
'The Great REIT Reset' - 4 REITs To Buy At A Bargain