2023-08-23 08:05:00 ET
Summary
- REITs are exceptionally cheap following their recent dip.
- That's despite posting strong Q2 results.
- We highlight two of our favorite opportunities to buy the dip.
The first- and second-quarter results of REITs ( VNQ ) had been overwhelmingly positive in 2023.
Rents keep on growing at an even faster pace than we had anticipated. Here are a few examples across various property sectors:
- Camden Property Trust's ( CPT ) same property NOI rose by 6.2% in the second quarter.
- AvalonBay Communities' ( AVB ) same property NOI rose by 6.3% in the second quarter.
- Alexandria Real Estate's ( ARE ) rent spreads were 14.5% in the second quarter.
- Whitestone REIT's ( WSR ) rent spreads were 17% in the second quarter.
- EastGroup Properties' ( EGP ) same property NOI rose by nearly 6% in the second quarter.
- STAG Industrial's ( STAG ) same property NOI rose by about 5% in the second quarter.
Bears will of course point out that interest rates are going up, but since REIT balance sheets are the strongest they have ever been, the positive impact of rent growth is typically greater than the negative impact of higher interest expense.
This explains why the cash flows of most REITs have kept on rising, and even the more heavily-leveraged REITs like WSR have been able to maintain stable cash flows.
But despite that, the market remains very pessimistic about REITs and this is well-reflected in their discounted valuations:
YCHARTS
Therefore, we think that today is still a great time to buy the dip in the REIT market. Here are two REITs that we are accumulating at the moment:
Alexandria Real Estate ( ARE )
Alexandria is a blue-chip REIT that typically trades at a low yield and relatively high valuation because it owns Class A life science buildings that enjoy steady growth, it has a strong investment grade-rated balance sheet, and one of the best track records in the entire REIT sector.
Class A life science buildings with rapid growth prospects:
Fortress balance sheet:
Alexandria Real Estate
Exceptional track record, outperforming even the likes of Walmart ( WMT ) and Berkshire Hathaway (BRK.A) ( BRK.B ):
It is arguably the cheapest and most opportunistic blue-chip REIT in today's market and so we think that it makes sense for investors who are looking for reliable and growing dividend income, but it also makes sense for investors who are seeking to maximize total returns.
Why is it so cheap then?
Jonathan Litt's short thesis continues to gain attention and it is hurting Alexandria's market sentiment.
But we think the short sellers are underappreciating the unique nature of Alexandria's life science clusters.
The short thesis focuses mainly on the drop in physical occupancy of the properties since the beginning of the pandemic. But this has been true for over 3 years already and yet, tenants keep renewing leases with very significant rent bumps. They actually recorded the biggest rent hikes ever in the first quarter of this year.
I believe that this is pretty strong evidence that it is wrong to equate low physical occupancy with low demand for life science space. Tenants may have learned how to work from home part of the time, but this does not remove the need to be in the lab/office at least a few days a week and all that valuable equipment also needs to be stored somewhere. In fact, the electricity consumption of its buildings has remained at an all-time high:
Alexandria Real Estate
Since posting our rebuttal, Alexandria has also provided additional evidence that the short thesis is likely missing something. They first announced that they had sold a few non-core assets at a 5.2% cap rate. These are not their best assets and they were still able to get a very attractive cap rate. Then a bit later, they announced that they had sold a JV interest in a property at a 4.5% cap rate. Once more, it shows you that these assets remain desirable.
Alexandria Real Estate
These cap rates are reflective of buildings that enjoy strong long-term organic growth prospects. Investors wouldn't accept paying such a low cap rate in today's interest rate environment if the future prospects were as bad as the short seller make it seem to be.
Yet, Alexandria is priced at a near 7% implied cap rate - and an even higher cap rate if you account for the large mark-to-market in its leases - a huge spread relative to the most recent market transactions (and this gives no value to the REIT's VC investments).
I really like the risk-to-reward because a lot of pain is priced in already, but the fundamentals remain rock-solid. In a future recovery, the share price could conservatively rise by 50%+ and we expect to earn a ~10% annual total return while we wait for the yield and the growth.
BSR REIT ( BSRTF )
BSR REIT is another great example of a REIT that has been unfairly punished. The REIT owns Texan apartment communities that enjoy rapidly growing rents and its balance sheet is in great shape, but despite that, its share price has dropped very significantly over the past year:
So far this year, its rents have risen by over 10% and this has resulted in 8% FFO per share growth.
Rising interest rates are of course a headwind, but since its loan-to-value is just 35%, the impact of rent growth has so far been far greater on its cash flow.
And we expect this to continue...
The rents of these properties are today still about 7% below market, allowing BSR to keep hiking rents as its leases gradually expire, providing a hedge against rising interest rates.
BSR REIT
The main risk right now is that there is a lot of new supply hitting the market, but this will at most cause a slowdown in growth for a year or two. After that, new deliveries are expected to fall off a cliff as it is today very difficult to start new projects given how high interest rates have risen.
Meanwhile, it is no secret to anyone that Texas is attracting a lot of people and companies and so we can expect the rents of these properties to keep on rising over the long run.
Despite that, BSR is now priced at a historically low valuation, trading at a near 40% discount to its net asset value, which essentially means that you get the chance to buy equity in these properties at 60 cents on the dollar.
On a cash flow basis, the company is now priced at a historically high 7.5% cash flow yield, out of which, it pays about 4% in dividends to shareholders and retains the rest to buy back shares.
Here is what the CEO said on the most recent conference call about their share buybacks:
"As long as our units trade at a significant discount to NAV, we see buybacks as an attractive option. We will continue to capitalize on opportunities to repurchase REIT units to drive stronger financial returns."
Closing Note
These articles may be getting a bit repetitive for some of you and I am sorry if that's the case.
But our accumulation strategy is by nature expected to be repetitive as we make small weekly additions to accumulate larger positions while prices are discounted.
We can't time the market, but we know that today's prices are historically low, and these purchases will be likely richly rewarded in the coming years.
For further details see:
2 REITs Most Investors Should Own