2023-05-26 07:00:00 ET
Summary
- It took some very tough lessons in life before I emerged with a mindset and determination to seek value without taking on excessive risks.
- While these hardships remain a distant memory, they’re constant reminders that define the traits of my investment strategy today.
- As Howard Marks wrote, “risk is inescapable” and the best way to mitigate risk is to grasp the principle known as the margin of safety.
This article was published at iREIT on Alpha on Wednesday May 24, 2023.
A few days ago I wrote an article titled " If I Were Starting Over In My 20s I Would Buy These REITs ." I enjoy writing articles like these so I can share some of my life experiences with others.
As most of my followers know, my life has been anything but normal, starting out in business (in my 20s) as a real estate developer, taking on outsized risk (without even knowing it) at a very early age.
As I tell my kids, I wish I had read The Intelligent Investor when I was in college and perhaps would be filthy rich right now. It took some very tough lessons in life before I emerged with a mindset and determination to seek value without taking on excessive risks.
While these hardships remain a distant memory, they're constant reminders that define the traits of my investment strategy today. As Howard Marks wrote, "risk is inescapable," and the best way to mitigate risk is to grasp the principle known as the margin of safety .
"The years of poverty since Father's death had touched me only lightly. They had developed in my character a serious concern for money, a willingness to work hard for small sums, and an extreme conservatism in all my spending habits." Ben Graham
What is the Margin of Safety?
When I was a scrappy real estate developer, I would always include contingency in my construction budgets. Typically, I would maintain a buffer of around 10% on hard costs for the so-called "what if" events.
Over my 20-plus year career as a developer I can assure you there were plenty of cost overruns:
- $100,000 to disassemble the metal building for Blockbuster Video after the building pad was two feet above grade.
- $500,000 to remove and backfill a site for Wal-Mart after unsuitable soils were found.
- $250,000 to repair a concrete slab for PetSmart after it was revealed there were microscopic cracks (I argued this one since all concrete cracks).
- $200,000 due to weather delays for an Advance Auto in Boone, NC (snows a lot there).
- $100,000 for Eckerd Drugstore due to lack of handicap ramps (civil engineer had to pay for this).
- $300,000 in free rent for Party City because there was a 7-for-1 penalty in the lease for delays in obtaining a certificate of occupancy.
- $500,000 paid to Bi-Lo because Dollar Tree was selling candy. There was a provision in the Bi-Lo lease that gave the company exclusive rights for "grocery" products.
All of these are real life examples, and without a contingency plan there would have been no ability for me to monetize these assets. Warren Buffett described it this way,
"You do not cut it close. That is what Ben Graham meant by having a margin of safety. You don't try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound tricks across it. And that same principle works in investing."
In the early years of my development career, I had a modest contingency plan, and it took a few tough lessons before I finally decided to build myself a larger cushion, because there's always room for error.
I remember the very first Advance Auto store that I built. I made around $20,000 on the deal and because I had no contingency plan I ended up having to pay for cost overruns related to faulty site work that cost in excess of $40,000.
That was a tough lesson, especially for a 27-year-old.
However, I got smarter each time and wound up building close to 40 stores for Advance Auto (valued at around $800,000 each). As Benjamin Graham defined it, the margin of safety constitutes a "favorable difference between price on the one hand and indicated or appraised value on the other."
Simply put, as prominent value investor and Columbia finance Professor Joel Greenblatt framed the concept in a 2011 Barron's interview,
"...it's about figuring out what something is worth, and then paying a lot less for it."
5 Strong Buy REITs with a Wide Margin of Safety
Boston Properties ( BXP )
Boston Properties is an office real estate investment trust ("REIT") with properties concentrated in Boston, Los Angeles, San Francisco, Seattle, New York and Washington, D.C. BXP's portfolio consist of 192 properties, totaling approximately 54.5 million rentable square feet.
As of year-end 2022, BXP's properties consisted of 173 office and life science properties, 14 retail properties, six residential properties, and one hotel. BXP in-service properties are 91.0% leased, have an occupancy rate of 88.6%, and a weighted average lease term ("WALT") of 7.6 years.
BXP is investment-grade with a credit rating of BBB+ by S&P Global. They have a fairly large amount of debt with a net debt to EBITDAre of 7.78x, a long-term debt to capital of 69.08%, and a fixed charge coverage ratio of 2.67x as of March 31, 2023.
BXP was one of our picks due to its large margin of safety. Over the past year, BXP's share's have fallen 52.80%, pricing the stock at $50.06 vs. our buy under amount of $100.0, giving the stock a 49.94% margin of safety.
BXP pays a 7.83% dividend yield that is well covered with a funds available for distribution ("FAD") payout ratio of 69.98%. BXP did not increase the dividend in 2021 or 2022, but over the last 10 years they have a compound dividend growth rate of 5.48%. Currently the stock is trading at a P/AFFO of 10.49x, which is a significant discount to their normal P/AFFO multiple of 29.71x.
We rate BXP a Strong Buy.
Hannon Armstrong ( HASI )
HASI is a mortgage REIT ("mREIT") that provides capital to companies that have a focus on climate solutions. HASI's investments center around projects that provide renewable energy, energy efficiency, solar energy, LED lighting, and other infrastructure projects that provide sustainable sources of "green energy."
HASI specializes in three markets related to climate solutions: Behind-the-Meter, Grid-Connected, and Sustainable Infrastructure. Their Behind-the-Meter market includes facility projects to increase energy efficiency through the use of solar energy, and other building improvements.
Their Grid-Connected market includes projects that generate power through solar, solar storage, and wind turbines, while their Sustainable Infrastructure market includes upgraded distribution systems including transportation fleet improvements and natural gas plants that more efficiently utilize natural resources.
HASI generates the majority of its revenue through interest income on loan investments but also derives revenue from rental income, sale of receivables, and fee income. HASI's total revenue increased from $186.9 million in 2020 to $239.7 million in 2022.
HASI is not yet investment grade with a BB+ credit rating from S&P Global. They have a long-term debt to capital ratio of 66.91%, a debt-to-equity ratio of approximately 1.7x, and HASI's debt is 86% fixed rate.
HASI's distributable earnings per share has increased at an 11% compound annual growth rate since 2014. In 2022, HASI's distributable earnings came in at $2.08 vs. the dividend of $1.50 for a 72.12% payout ratio when based on distributable earnings.
HASI has a compound dividend growth rate of 6.30% over the last eight years and currently pays a 5.90% dividend yield that's well covered by their distributable earnings. Currently the stock is trading at a blended P/E of 12.48x, which is a significant discount to their normal P/E multiple of 19.06x. We have a buy below target of $52.00, giving HASI a 48.50% margin of safety.
We rate HASI a Strong Buy.
Safehold ( SAFE )
SAFE is a REIT with a focus on ground leases. SAFE acquires and owns the land underlying commercial real estate and leases it out to the building owner, typically on a triple-net basis.
Ground leases have unique characteristics such as long duration lease terms that typically range between 30 and 99 years and residual rights, which allows SAFE to take possession of the building that sits on their land once the lease expires.
One other feature to point out is that if the building owner defaults on the ground lease, and the lender (which is a subordinate creditor to SAFE) does not make SAFE whole, then SAFE can take possession of both the building and the land at no additional cost.
Multiple property types sit on SAFEs land including multifamily, office, hotel, mixed-use and life science properties. By property count, multifamily makes up SAFEs largest category with 69 properties, while life science is their smallest category with five properties.
Another unique aspect of SAFEs business is their caret program. Due to the fact that SAFE will ultimately take possession of the real estate sitting on their land (once the lease expires), they track the value of the assets and record unrealized capital appreciation if the market value exceeds their cost basis.
They track and monitor the unrealized capital appreciation in their residual portfolio and created caret units to reflect the value of that portfolio. The caret units are sold to investors enabling the caret unit holder to participate in the proceeds once the capital appreciation has been realized.
SAFE is investment grade with a credit rating of BBB+ from Fitch and Baa1 from Moody's. They have $4.2 billion in total debt and $2.2 billion in total book equity for a total debt-to-book equity ratio of 1.9x. Additionally, they have a total debt-to-equity market cap of 2.3x.
While their debt metrics are somewhat high, this does not impact SAFE as much as other REITs due to the unique structure of their business. They have no property obligations that would cut into their margins and have the longest debt maturity schedule of any REIT.
SAFE's diluted earnings and dividend per share have grown each year since 2018. Currently SAFE pays an annual dividend of $0.694 per share. At today's price of $26.40 this equals a 2.63% dividend yield. SAFE's payout ratio has dramatically improved from 93.07% in 2018 to 31.15% in 2022.
SAFE currently trades at a trailing P/E of 11.95x, which is the lowest valuation they have traded at in the last three years. Earnings have increased over this same time period while the multiple has contracted. We assign a buy under price of $47.00, giving SAFE a 42.91% margin of safety.
We rate HASI a Strong Buy.
Digital Realty ( DLR )
Digital Realty is internally managed REIT that acquires and owns data centers. DLR owns or has an ownership interest in 314 data centers that contain over 200,000 cross connects and has a global presence with data centers located in the U.S., Africa, Asia, Europe, Latin America, Canada and Australia. In total, DLR has properties located in 28 countries and on 6 continents.
DLR has more than 4,000 customers, an average weighted average remaining lease term of 4.7 years, and as of the end of the first quarter, DLR's data centers had an occupancy rate of 83.5%. Data centers play a crucial role in e-commerce as they process incoming data that is then organized and routed to the appropriate distribution center for online fulfillment.
DLR - Investor Relations
Much of the short campaign waged against DLR recently revolves around hyperscalers (Microsoft, Google, Amazon) building out their own data centers which would impact DLR's bookings. But this runs contrary to DLR's actual reported bookings in recent years and record interconnection bookings in the fourth quarter of 2022.
DLR is investment-grade with a credit rating of BBB. Their net debt to adjusted EBITDA was 6.9x and their fixed charge coverage ratio was 4.9x as of the fourth quarter of 2022.
Their debt is 97% unsecured, 81% fixed rate, and has a weighted average interest rate of 2.7% with a weighted average term to maturity of 5.2 years. DLR has minimal maturities in 2023, plus they have $131.4 million of cash and cash equivalents and $1.1 billion of availability under their revolving credit facilities.
DLR has increased its dividend for 17 consecutive years and pays a 5.33% dividend yield that is well covered with an AFFO payout ratio of 82%. They have an average AFFO growth rate of 5.71% since 2013 and a compound annual dividend growth rate of 10% since 2005.
DLR pays a high yield and has an excellent dividend growth track record. They have solid AFFO growth rates which should persist as e-commerce continues to grow. Analysts expect AFFO to increase by 3% in 2023 and then by 6% and 7% in the years 2024 and 2025, respectively.
Currently DLR trades at a P/AFFO multiple of 15.08x, which is well below their normal AFFO multiple of 19.15x.
We rate DLR a Strong Buy.
(Note: I'm working on a detailed article now examining the short thesis and highlighting our reasoning for doubling down).
Alexandria Realty ( ARE )
Alexandria is technically an office REIT, but really should be categorized as a life science REIT. They're unique in the office sector in that they lease laboratory space to pharmaceutical companies, medical device companies, academic research, and biotechnology companies that are resistant to the work from home movement.
They have properties in Boston, San Francisco, San Diego, New York, Maryland, Seattle and Texas. As a percentage of ARE's rental revenue, Boston is their largest market at 36%, followed by San Francisco at 22%.
ARE's portfolio consists of 64 operational properties and development projects or future development projects, giving a total asset base that covers 74.6 million square feet and serves around 1,000 tenants. Occupancy rate is 94.8% for their operational properties.
ARE has some of the best debt metrics you can find in a REIT. They have a BBB+ credit rating, a net debt and preferred stock to adjusted EBITDA of 5.3x, a fixed coverage charge of 5.0x, and a long-term debt to capital ratio of 38.41%.
ARE's debt is 96.1% fixed rate with a weighted average interest rate of 3.73%, a weighted average term to maturity of 13.4 years and they have no debt maturing before 2025. Plus, they have $5.3 billion in total liquidity, which should provide plenty of flexibility for future investments.
ARE has an average annual AFFO growth rate of 5.56% since 2013 and an average dividend growth rate of 5.4% over the last five years. They pay a 4.11% dividend yield that is well covered with an AFFO payout ratio of 72.17%.
ARE's conservative payout ratio enables ARE to retain a large portion of their operating cash flow for future investments, which makes them less dependent on raising capital through debt or equity issuance.
To some extent, ARE has been lumped together with the rest of the office sector and has seen their stock price decline by -27.73% over the past year. However, as previously mentioned, ARE is not a typical office REIT. In my opinion the sell-off has been overdone due to the fact that ARE is not impacted nearly as much as the rest of the office sector from the work from home movement.
ARE is currently trading at a P/AFFO multiple of 17.48, which is a steep discount to their normal P/AFFO multiple of 24.21x. We assign ARE a buy under price of $170.00, giving them a 31.31% margin of safety.
We rate ARE a Strong Buy.
In Closing…
REITs generally provide reasonably low-cost exposure to relatively high-quality pools of real estate assets. As mentioned previously, I recently launched a new REIT ETF Index that provides exposure to high quality US-listed common and preferred equity securities of REITs while ensuring sector diversification.
Although this strategy is unique to the REIT ETF regime, it's nothing revolutionary in that we took the same page from Ben Graham's intelligent investor classic:
"You are neither right nor wrong because the crowd disagrees with you. You are right because the data and reasoning are right."
Simply put, to make intelligent decisions, the investor (or ETF Index) must select sound (high quality) securities that are trading at a wide margin of safety.
As Graham defined it, the margin of safety constitutes a "favorable difference between price on the one hand and indicated or appraised value on the other."
As a Ben Graham disciple, I'm patiently waiting for the storms to subside, knowing that a sunnier time is around the corner. Sir John Templeton summed it up best:
"To buy when others are despondently selling and sell when others are greedily buying requires the greatest fortitude and pays the greatest ultimate rewards."
For further details see:
5 'Strong Buy' REITs With A Wide Margin Of Safety