2024-01-01 08:25:00 ET
Summary
- REITs have begun to rally.
- Many of them still offer significant upside potential.
- We present three REITs that are still priced at exceptionally low valuations.
Right now, REITs are still priced at near their lowest valuations in a decade, but I think that the window of opportunity is closing.
That's because interest rates are expected to return to lower levels in 2024 and still should be a strong catalyst for the entire REIT sector ( VNQ ).
After all, the only reason why REIT share prices crashed in 2022 and 2023 was the rising interest rates, so if interest rates now start to decline, this should have the opposite effect.
This has already started...
But this is still just the beginning for a lot of REITs.
A lot of them are still down 30%, 40%, or even 50% and continue to trade at exceptionally low valuations. Here are three good examples that we are accumulating at the moment:
Healthcare Realty ( HR )
On paper, Healthcare Realty seems like a great opportunity.
It is the leader in the medical office segment of the market, it has guided for 5% FFO per share growth in the coming years, it has a BBB-rated balance sheet, and yet, it is still priced at a 45% discount to its recent peak.
The discount is similar to that of other office REITs like SL Green ( SLG ) and Boston Properties ( BXP ) so it seems to me that the market has priced HR as if it were just another office landlord.
However, medical office buildings are far more resilient than traditional office buildings.
Yes, telemedicine has made a lot of progress, but in most cases, doctors are still at their medical office buildings even for remote consultations. Moreover, it just isn't possible to do it all digitally. The employee of a regular company may be fully remote and never go to the office, but that just isn't possible for a doctor who needs to evaluate patients in person to do various tests.
All of this is especially true for HR's properties because they are located in medical clusters of rapidly growing sunbelt markets:
Medical clusters enjoy significant barriers to entry, limiting the competition from new supply, and the strong population growth in these markets coupled with the aging population should serve as strong catalysts to boost demand over the long run.
For these reasons, HR has guided for strong growth in the years ahead as it increases its occupancy rate and its rents.
But the market isn't listening to their conference calls, it seems, and the focus remains on the headwinds impacting the office sector.
I think that as HR proves the market wrong and interest rates return to lower levels, the market will eventually reprice HR at a materially higher level because a company of this quality shouldn't be priced at just 10.5x FFO and a 7.3% dividend yield.
The upside potential could be up to 50%.
Vonovia (VNA/ VONOY )
We wrote a lot about Vonovia when it was priced at €15-20 per share and made many purchases of the stock in that range.
Today, the share price has already recovered to €28 per share, practically doubling off its lows, and yet, it remains heavily discounted.
In case you are not familiar with Vonovia, it is the biggest landlord in Europe, owning 500,000+ apartment units, mainly in Germany, but also in Austria and Sweden.
Vonovia
Today, its net asset value is €50 per share and historically, the shares have traded at a ~10% premium to its net asset value during most times. This means that under normal circumstances, VNA should trade at around €55, but you still get to buy it today at just half of that.
But for how much longer?
The only reason why Vonovia got so cheap was that the market became concerned about Vonovia's ability to handle its debt maturities following the surge in interest rates.
But these fears are now slowly disappearing because:
- (1) Vonovia has made great progress selling assets at near their net asset value and paying off near-term maturities. As a result, Vonovia is now in a good position to handle its limited debt maturities.
- (2) Interest rates are expected to be cut in 2024 and even further in 2025.
- (3) The transaction market is recovering in Germany and property values are even expected to increase in 2024 as interest rates return to lower levels.
We have argued all along that the market was overreacting because Vonovia has a strong BBB+ rated balance sheet, well-laddered debt maturities, and enjoys growing rents.
The market is now slowly coming to this same conclusion and the discount to NAV has begun to close, but there is still nearly 100% upside potential to its historic valuation.
Will it get there in one year?
Probably not, but as interest rates return to lower levels, and Vonovia's net asset value starts to appreciate again, I expect a lot of investors to rush back into Vonovia.
Today, it still offers a 9% cash flow yield, out of which it pays 3% in dividends, and reinvests the rest in deleveraging the balance sheet.
Whitestone REIT ( WSR )
WSR specializes in service-oriented strip centers and most of them are located in rapidly growing sunbelt markets like Phoenix, Austin, Dallas, and Houston.
Whitestone REIT
The interesting thing about these retail properties is they are benefiting from the rapid population growth that's happening in these markets, but unlike some other property sectors, there has been relatively little new supply of retail space hitting the market in recent years.
This puts WSR's properties in a strong position to grow rents, especially since its current rents are deeply below market levels. Its releasing spread has consistently been 15%+ in recent quarters, and that's on top of the 3% annual rent escalations that it has in its leases.
Overall, WSR's rent growth has been some of the strongest in its sector and this is likely to continue:
For these reasons, I have previously argued that WSR owns some of the best assets in its peer group, but despite that, it is today priced at one of the lowest valuations.
P/FFO | |
Whitestone REIT ( WSR ) | 11x |
Regency Centers ( REG ) | 17x |
Federal Realty Investment Trust ( FRT ) | 16x |
But maybe not for much longer.
The two main reasons why WSR has been discounted relative to its peers are only temporary.
Firstly, WSR has been defending a lawsuit from its former CEO, who sued WSR after being fired for cause. This cost WSR a lot of money in legal fees, but just recently, it announced that it had won the case in court.
Secondly, WSR's leverage has been a bit higher than the sector averages, and while it has been rapidly deleveraging its balance sheet, this has been masked by all the recent legal fees.
If you remove the legal fees and WSR keeps making similar progress, its balance sheet will be comparable to its peers a couple of years from now, and the market won't have a good reason anymore to price it at such a steep discount.
Simply returning to today's net asset value could unlock about 30-40% upside potential, and while you wait, you earn a 9% cash flow yield out of which about half is paid in dividends, and the rest is retained for deleveraging and growth.
Closing Note
The REIT market has now begun its recovery, but it still has a long way to go.
A lot of REITs remain heavily discounted and offer significant upside potential in 2024.
For further details see:
3 Once-In-A-Decade REIT Buying Opportunities