2023-09-29 05:29:40 ET
Summary
- Investing in out-of-favor sectors can lead to good deals.
- The REIT sector is currently out of favor due to various reasons.
- Alexandria Real Estate is a solid REIT option with specialized properties in the biotech/lab sector.
Dear readers/followers,
I heavily favor companies and sectors that are out of favor by the broader market. I do this because I know that chances are if there are good deals on offer, I'll find some of those deals in sectors that are already under pressure. In fact, one of my biggest mistakes in investing , has been made by not taking advantage of weaknesses - such as the weakness we saw in Energy/oil a little over a year ago.
However, I'm sure you can name many more.
The fact is, the market is very prone to overreacting. If you've been "in the game" for a while, you start to recognize those tendencies. The equivalent of someone screaming bloody murder, only to then after a while go back and say "Oh well it wasn't that bad...". Or maybe, as in some cases, the perceived weakness wasn't much of a weakness or an issue at all. That can also happen and has happened.
So if you know this - when a sector is out of favor, you have the opportunity to really double down on some quality companies if you do your picking carefully.
So how do we do careful picking?
Carefully picking only 2 REITs
In this case, I want to focus on the REIT sector - because property and real estate are currently massively out of favor due to several reasons. Interest rates, the leveraged state of the property sector, especially things like offices - it's all a perfect storm that is pushing the property sector and REITs specifically, down.
Some sub-sectors in REIT-dom are much more down than others. And while it's possible to say that you invest only in REITs yielding over 8% here to really get a juicy yield, my M.O. is somewhat different to ensure that I get the best possible companies that are available at a good price.
So - my list includes:
- A conservative upside to a 5-year P/FFO of at least 15% per year.
- A yield of at least 4%
- A credit rating of at least BBB+ or above.
- No dividend cuts in the last 10 years or significant earnings declines posing fundamental risks during the GFC.
These demands alone filter out about 90% of REITs - because that BBB+ or above is really something that's hard to find - forget the part about dividend cuts.
However, there are two absolutely solid REITs that qualify here - and here they are, in alphabetical order.
1. Alexandria Real Estate ( ARE )
Alexandria Real Estate is the biggest Office REIT holding I have. It's over 1.5% of my portfolio at this point.
Wait, did I say "Office REIT"?
Technically, ARE is an "Office REIT" - but this is a misnomer. When you think offices, you usually think of your typical cubicle environment that's inherently replaceable by any other building with four walls, a roof, and some power outlets.
That's not what Alexandria offers.
Alexandria focuses on mission-critical properties in the biotech/lab sector. Their properties always come with extremely specialized applications. It doesn't own hospitals, nursing homes, or other similar facilities. Instead, it focuses on buildings housing lab space and research space that pharma and healthcare companies cannot be without.
ARE IR (ARE IR)
The company has made a business out of exactly owning the sorts of buildings that, regardless of economic environment, would be considered attractive by its tenants, and non-optional.
That's why you see extremely limited indicators of any sort of payment delinquency. Collections are at 99.9%. It's why, despite the environment, the company has over $6B worth of liquidity. Alexandria also has no debt maturing prior to 2025 , and its debt is fixed at 3.69% with an average maturity of 13.4 years. Name me the REIT, office or otherwise, that manages this.
It's also why tenants seem to love ARE and consider them a part of their core. That's why 80% of the leasing activity in 1H23 alone was from an already-existing client base for ARE.
It's why company rental growth on a cash-base rental rate is over 14% for the year so far, with a WALT of 8.4 years.
It's also why, unlike other office REITs, the company manages a 95%+ occupancy and has been above 93.5% since before the GFC.
So, no. You cannot call ARE an "office REIT" without a massive sort of asterisk, because it's not comparable to the admittedly higher-risk office REITs I also invest in. Lately, however, most of my capital has been going to ARE to really beef this position up.
Why?
Simply - valuation.
To illustrate how far the mighty have fallen, I give you this.
I will be clear to you in saying that I would never "BUY" ARE at the valuation we saw between 2013-2022. Maybe that one time we saw normalization during 2015 - but beyond that, I wouldn't buy ARE for a high premium, and this is despite a significant growth rate for the company as you can see since the recovery after the GFC. If we look at GFC numbers, the "bottom" there was between 6-8x P/FFO. I would say that we're not in the position to expect another GFC or another GFC-style drop in the company.
Unless you think this, I give you this upside to a conservative 15x P/FFO, which is over 6x P/FFO below the premium of 21.7x on a 5-year basis.
That's a 60%+ RoR in 3 years based on BBB+ with a 5% yield for a very solid company, even when considering the forward valuation significantly below any sort of premium.
If you even consider for a moment giving the company a premium approaching its historical level, you're able to see an upside not to almost 25% per year, but to 45% per year at a 21.7x P/FFO , or 131% in a little less than 3 years.
Even if the company was to drop to 8-9x P/FFO, you would still not be losing money under the current set of estimates. For that, we'd have to see declines to 7.5x P/FFO. Given that there is no indication of an FFO drop in the company's future, I believe such forecasts hold very little water, even if the macro is currently very unfavorable to REITs like Alexandria.
Well, you might ask - just how safe are those forecasts? Because after all, we can't give much credence to forecasts that basically just say A, but then have little safety.
While I can't speak to forward accuracy, this is historical accuracy.
F.A.S.T graphs Forecast Accuracy (F.A.S.T graphs)
That's 100%, with the above-mentioned margin for error. There's very little ambiguity or uncertainity to this.
Part of my strategy is being a market contrarian when I can make a case for why the market is "wrong". On this REIT, I firmly believe that not only is the market wrong, but I actually believe the market is dead wrong.
I believe ARE represents an absolutely superb opportunity, and that's why I am a "BUY" here.
I own over 1.5% of my commercial and private portfolio in Alexandria Real Estate.
2. Realty Income Corporation ( O )
Nay-sayers about O are becoming more and more common, it seems like. And I wouldn't dream of discounting their opinions or stances without first taking them in and weighing them - so I have.
But it remains my stance that they are viewing the company with a degree of short-sightedness.
Realty Income is my #1 REIT holding and my #1 non-European investment holding. Over 3.5% of my portfolio, both commercially and privately, is Realty Income.
There are reasons for this. There are also reasons why I am completely unfazed by the recent action.
I believe the company is worth every penny of its historical premium. Now, that historical premium is, I believe, lower than some investors might expect.
But as the company is trading today, I believe it would be downright foolish to ignore what the company has to offer and what you could make by investing.
There aren't many companies out there that can boast of what Realty Income has going for it. I hasten to remind you, that my own cost basis for O is well below $60/share to begin with. I had the luck (and strategy) to buy the company very cheaply to begin with. This, coupled with the current FX, means that O is actually not in the red for me at this time.
At $60B worth of enterprise value and a market cap of over $40B, this is one of the largest businesses in the space. It's heavily US-weighted, with only slight exposure to Europe, though that is growing as well.
The company's unbroken record of dividends, as well as significantly impressive compounded TSR and over 97% positive earnings growth on a per-year basis, makes this company one of the best real estate companies in existence.
You can argue about headwinds and other concerns here, but the fact is that the company outperforms even the trends we're seeing today. Realty Income outperforms the Fed Rate cycle - at least historically. The company is also positively correlated to short-term yields. That's a way of saying that even during difficult times, Realty Income tends to do very well. The company has the lowest operational and financial volatility of all REITs that are in the same division (A-rated, S&P500).
I won't argue the fact that growth has become more complex during the last few years, and going forward, I don't think the company will have as "easy" a time getting the growth rates it's used to. But the company is at such a scale and with such advantages at this time, that there is very little fundamental or macro that could seriously de-rail the company's growth estimates here.
Risks and concerns? Walgreens ( WBA ) and other somewhat negative tenants and sub-sectors are in for a downturn or a more risky outlook. The company has a few of those, including some remaining AMC exposure. But the biggest risk in terms of ABR is Walgreens. And even if the company, which in this case I'm pretty bearish on, is going through troubles, they'll still be paying their rent for the foreseeable future. While they may, and are downsizing, this will be a gradual process that hopefully allows O to monetize and re-use some of these assets to at least prevent the worst type of impact.
A glance at company cash flows confirms that trends confirm the positive thesis.
All of the company's fundamentals are also solid. Some of the more important metrics, such as the investment spreads for the company, have a proven trend to remain at a very attractive levels of around 6-8% which we've also seen historically - but it takes the cap rates some time to adjust for the fluctuations in interest rates.
There's also far too little talk about how recessionary environments result in significant investment opportunities. The previous recessions, including the tech bubble, the GFC, and COVID-19, resulted in a 10-year treasury/cap rate spread of upwards of 600 bps. I am probably not the only one somewhat even hoping for a fundamental downturn which, while resulting in a pressured company valuation, should result in market outperformance in the long term.
Remember, in order to see a significant upside, you typically need to start from a position of low valuation. That position of low valuation can come because you invest in a company at the beginning of its "journey" - but more typically, as I see it, it's because that company is cheap at the time due to share price pressure.
The benefits of the company's scale should not be underestimated here. Realty Income has a G&A of less than 4% of its total revenue while maintaining a 95.2% adjusted EBITDA margin and less than 35 bps of its G&A as a percentage of its real estate book value.
The comparison to other net lease peers has peers at more than double the G&A and less than 90% adjusted EBITDA margin. To call Realty income a well-oiled machine would be an understatement, as I see it.
Risks are not unknown to O, as I've said. The typical ones mentioned include the European portfolio and expansion into non-typical sectors as a product of trying to improve yields and growth. There are also arguments about the rising cost of capital eroding some of the advantages from previous M&As and the company "floundering" a bit in relation to its previous strategy, such as the recent acquisition of the Bellagio.
I say these risks, while relevant, miss some of the larger points remaining in the company's favor. Realty Income remains one of the best-rated and best-managed REITs out there.
It is not, and I repeat, it's not expecting any sort of FFO decline. It may be slower growing, but the boost of 35% of FFO in 2022, materialized.
What we have here, is like with Alexandria, a company that is looking at a near-flawless 100% accuracy ratio for its forecasts. It's also now yielding 6%, which is at a near-record level. Even if you forecast Realty Income only at a 15x P/FFO, you're getting 18.9% annualized at this time. When I realized this, this was what convinced me. Previously, we had to legitimize that premium to get those returns - that is no longer necessary thanks to valuation.
In the case of premium normalization, which by the way I consider completely valid in the long term, this is what that looks like.
So, that's a near triple-digit RoR in less than 3 years from one of the best REITs out there. You can argue against the various valuation levels of the company if you want, but the fact is that Realty income would have to drop to a level below 10x P/E to turn negative RoR for this investment in the next 3 years.
I consider such a development to be extremely unlikely, even in the face of low growth of less than 5% per year. And even if it was to drop to that level, I would buy more of the company.
So, let's wrap up.
Wrapping up these investments
I realize that many of you may be uncertain as to what to invest in here, or whether your timing at this moment is "right" to go in - regardless if you decide to go for this specific investment or not.
To that, I would say that your timing only matters somewhat - valuation is what matters more when it comes to successful investing. If you continually invest in companies when they are at multi-year or decade-low valuations, and you combine this with investing only in qualitative companies, then your chance for a reasonably successful investment outcome is high, in my view.
Let's take an example. Some investors consider the companies I have presented to you to be substandard and more viewed as "income investments", especially O.
That's not how I view O.
O is an income investment to some degree, for sure. But the key differentiator here is that the yield/income only acts as a buffer/minimum. The thesis is based on the total upside.
Even if this takes, let's say 3-5 years. Let's say you get an 80-100% RoR in 3-5 years. Based on what you see above, this might not be unlikely. You need to realize that if you get this, you're vastly outperforming even the most average investors. A 10% annualized RoR means around a 7-year rate of "doubling" your investment. If you can do it in 3 or 5 years, you've really beaten that average.
That's what I did the past 8 years. I managed to, through value investing, get 2 "doublings" in my portfolio in a relatively short period of time - well better than the average.
It's those strategies that I share with you here today. This is how I invested in order to achieve that.
These two REITs are my current highest-conviction REIT buys - and I recently/today bought more in both.
Questions? Let me know.
For further details see:
Alexandria And Realty Income: My Current 2 Biggest 'Buys'