2023-09-26 08:05:00 ET
Summary
- Not all REITs are worth buying.
- Valuations are low across the board, but risks are high as well.
- We highlight 1 REIT to sell and a better alternative to consider.
Just because two companies share the "REIT" acronym does not mean that they have anything in common.
There are over 200 REITs in the US ( VNQ ) alone and they invest in over 20 different property sectors:
- Office
- Industrial
- Apartment
- Retail
- Hotel
- Net Lease
- Senior housing
- Skilled nursing
- Hospital
- Medical Office
- Manufactured Housing
- Single-Family Rental
- Student Housing
- Self Storage
- Timberland
- Farmland
- Prison
- Billboard
- Data Centers
- Infrastructure
- Ground Lease
And that's not all.
There are also additional REITs in 30+ other countries:
NAREIT
And so when I say that I am bullish on REITs, it does not mean that I am bullish on "every" REIT. Yes, I have a big chunk of my net worth invested in REITs, but I would still stay away from most of them.
This is one of those sectors in which you need to be very selective because it is filled with landmines, and I am talking from experience, having lost a lot of money investing in the wrong REITs at times.
In today's article, I am going to highlight one such risky REIT to avoid and one 'Strong Buy' that I am accumulating at the moment:
SL Green ( SLG )
There are a lot of things to like about SLG and it is not surprising to me that it is attracting a lot of investors:
- It owns "Class A properties" in Manhattan, which for a long time has been perceived as a safe-haven market with significant long-term demand tailwinds, but limited new supply growth.
- It has a great management team. They know their specialty better than anyone else and have the shareholder's best interests at heart.
- They offer a 9% dividend yield that's paid on a monthly with a seemingly low payout ratio.
- Its share price has crashed and as a result, its valuation is now historically low, trading at 7x FFO and a large discount to NAV - at least if you base your NAV on the cap rates of recent years.
SL Green
But here's the main reason why I wouldn't buy it even at these levels:
SLG is very heavily leveraged.
In fact, it has the most leverage out of all office REITs.
Its Debt-to-EBITDA is very concerning:
Not just that, it also has more maturities than average coming its way over the next years:
That's a big issue, especially today.
Jonathan Litt, a famous activist REIT investor, recently went on CNBC and explained that " winter is coming " in the office sector:
We talked a lot about "return to the office". It is not about return to the office anymore. It is about refinancing. We have $400 billion coming due over the next several years... They are 80% LTV... You can't get 80% LTV loans so there's going to be a very cold winter for office as we get through this refinancing wave. Stocks are trading at a 10% cap rate. That may look expensive as we roll through this.
He then later added that: " New York is going to be very difficult " when asked about particular markets that will suffer even more than average. It remains today one of the weakest markets in the US with an oversupply of office space and people moving away into business-friendlier states and cities:
And I would add that SLG does not own just new modern class A buildings. A large portion of its portfolio is also older properties that will require substantial capex in the coming years to keep them desirable.
So when you take all of this into account, I fear that SLG is likely to turn into a value-trap.
Its share price recently doubled after some encouraging news about the "return to office" came out, but as Litt pointed out the real story is going to be about refinancing in the coming years, and from that perspective, SLG is going to be very challenged.
Cap rates have expanded for these assets, NAVs have come down, and LTVs are going up even as capex and interest expenses are surging.
That's a tough mix to deal with.
Now if you adjust the FFO for the needed capex, the compressing NAV, as well as the urgent need to deleverage, you will likely conclude that the valuation is not quite that low after all, especially if you expect office space in Manhattan to remain challenged for a while.
At the very least, you would likely agree that there is significant uncertainty and so at best, this is a high risk / high (potential) reward pick for those who are bullish on the office sector.
I don't see the point of it when there are so many better opportunities in the REIT sector.
BSR REIT (HOM.U / OTCPK:BSRTF )
The main reason why people are buying REITs like SLG is because they are seemingly discounted relative to the value of their underlying properties.
This may well be true.
But the issue with SLG in particular is that cap rates are expanding for its assets and when you pair that with high leverage, your discount can quickly disappear.
The assumptions used for NAV models with a REIT like SLG are highly uncertain and a small change in assumptions can lead to very different results.
With that in mind, consider BSR REIT.
It owns apartment communities in rapidly growing Texan markets, which are in some ways the opposite of NYC offices.
- Office is hated. Multifamily is loved.
- NYC is hated. Texas is loved.
These are properties that are in high demand and there's lots of capital chasing after these assets.
Just recently, UDR ( UDR ) announced that it was going to acquire a portfolio of apartment communities that are very similar to that of BSR at a 4.5% cap rate or $230k per unit.
But despite that, BSR is today priced at a 6.7% implied cap rate or about $160k per unit. These are the same markets, comparable property age, and occupancy.
BSR REIT
Could the discount be the result of overleverage or poor management?
No.
BSR has a good balance sheet with a conservative 38% LTV and it has a shareholder-friendly management team with significant skin in the game, as they are implementing a share buyback plan to take advantage of the discount.
So put simply: It has very desirable assets, a good balance sheet, and management. But despite that, it is now priced at a 40% discount to its latest net asset value and we have recent comps to provide further evidence that it is really discounted.
With that in mind, I would argue that the risk-to-reward of BSR is far more desirable than that of SLG.
Closing Note
BSR owns great assets that are in high demand and likely to experience significant growth over the long run. Its Texan markets keep attracting lots of companies, jobs, and people; BSR owns great locations, and its rent-to-income ratios remain far lower than the national average.
SLG, on the other hand, is sitting on a huge pile of older office buildings with uncertain long-term demand, significant capex requirements, and too much leverage, making it tough to even refinance.
Given that both are discounted, why would you go with SLG instead of BSR?
Both can be rewarding but the risk-to-reward of BSR is superior.
For further details see:
1 Risky REIT To Avoid And 1 Strong Buy