2023-09-13 15:14:54 ET
Summary
- Higher interest rates have made many dividend paying stocks and equity-type instruments less attractive compared to risk-free rate alternatives.
- In the past during the ultra-low interest rate environment there was a desperate search for yield, where REITs provided a part of the solution.
- Now, the overall REIT market has also become less attractive. This means that investors have to be selective.
- GMRE and SPG provide nice exposure towards higher yielding cash flows underpinned by resilient business operations, strong balance sheets and promising growth prospects.
Since early 2022, when the FED pivoted from an accommodative monetary policy to a clearly restrictive approach, fixed income instruments have become rather attractive.
As a result, equities and other inherently more risky securities have lost their attractiveness for the yield-seeking investors, at least on a relative basis in the context of fixed income alternatives.
This is a seismic shift considering the previous 10+ years, which were dominated by ultra-low interest rates and investors' efforts to seek a meaningful yield by going up the risk curve.
Historically and during the pre "Jay Powell" era, REITs provided an interesting solution for many yield-seeking investors. By investing into REITs, investors could avoid an assumption of too high risk and still receive a yield that is meaningfully above the fixed income benchmark.
However, the magnitude of the recent interest rate hikes has been so notable that even REITs (their yields) have become unattractive.
The chart above uses the U.S. 10-year Treasury as a yardstick. If we factor in the prevailing T-bill rate, which as of now yields ~5.2%, the spread sinks in the negative territory even deeper.
Here we can see that the Vanguard Real Estate Index Fund ETF Shares (NYSEARCA: VNQ ), representing the overall U.S. equity REIT market, offers ~3.5% dividend yield, which corresponds to a 10-year high. The yield on the SPDR S&P 500 ETF (NYSEARCA: SPY ) has remained more or less flat at ~1.1%.
Compared to either T-bills or 10-year Treasury notes, neither VNQ or SPY is able to satisfy investors, who seek juicy streams of income exceeding the risk-free rate.
As a result, investors are left with a trilemma : there is a demand for a higher yield than what is embedded in the risk-free instruments, which if achieved most likely implies an excessive assumption of risk or if a decision is made to stick with ~5% yielding T-bills, the yield-growth prospects are virtually non-existent.
In my opinion, this is the right environment to be a selective stock picker (especially for those, who chase safe and high yield), where a pure replication of overall indices are likely to result at suboptimal streams of income.
In this article below, I will highlight two U.S. equity REITs, which deliver on the following aspects:
- offer more attractive yield compares to the U.S. risk free alternatives,
- carry financially resilient balance sheet and financing structures,
- embody favourable long-term growth dynamics.
Global Medical REIT (NYSE: GMRE ) - 8.8% dividend yield
GMRE is net?lease medical office REIT that acquires specialized healthcare facilities and leases those facilities to strong healthcare systems and physician groups with leading market share in secondary and tertiary markets.
While GMRE has only ~$650 million in market cap, it owns 186 properties, which are spread across 35 states and as of Q2, 2023 were 97% occupied.
The key mechanism how GMRE creates value for its investors is by scoping properties with high cap rates, acquiring them above the WACC rate and then enhancing via additional CapEx and / or fresh tenant mix.
Historically, GMRE has bought and held the properties and in instances, where more sizeable transactions were involved, it issued additional shares to fund these deals. This way, GMRE has managed to keep the dividend stable and capture a well-needed diversification benefit.
However, in the recent quarters GMRE has put a focus on asset rotation by divesting some of its properties and purchasing higher yielding assets instead. A notable chunk of the received proceeds has gone to debt reduction activities. All in all, the recent divestitures have been made at 5.5 - 6% cap rate levels, which are clearly below the weighted average portfolio cap rate of 7.9%. It sends a strong message on the underlying (hidden) value of GMRE's portfolio.
As a result of this GMRE has managed to optimize its balance sheet and structure its financing profile to both neutralize the interest rate risk for the next 4 years and position its capital structure to act opportunistically.
GMRE's balance sheet with a leverage ratio of 44% and almost a complete isolation of interest rate risk in the foreseeable future is supported by resilient cash flow generation.
The tenant mix is strong with very healthy rent coverage ratios, implying distant risk of delayed or reduced collected rent levels. The fact that during COVID-19 period, GMRE was able to maintain stable AFFO generation and service its lucrative dividend.
The weighted average lease terms is also favourable at 5.8 years allowing GMRE to approach renegotiations steadily, while avoiding cost inflation due to net-lease principle and benefiting from ~2.1% of embedded rent escalators.
While GMRE's current AFFO payout ratio is 98%, the results of recent asset rotations, locked in financing costs and steadily growing same-store NOI provide the dividend seeking investors with a comfort to safely count on the 8.8% yield going forward.
Simon Property Group (NYSE: SPG ) - 6.6% dividend yield
SPG is a way more straight forward case compared to GMRE that is also partially reflected in lower dividend yield. The dividend yield of 6.6% is still attractive at 6.6% and provides with ~150 basis points in premium relative to the risk-free rate instruments. In contrast to GMRE, SPG has a more pronounced growth element with even more reduced financial risk and conservative capital structure.
SPG is one of the largest U.S. publicly traded equity REITs with a market cap of ~ $40 billion that needs no detailed introduction. From the IPO through year end 2022, SPG has achieved a total return of ~2,400% translating to a compound annual return of about 12%.
The essence of SPG is location, location and location, where it holds class A and trophy mall properties located in areas in which there is and will be a structural demand by consumers to spend.
Over the past 10-years SPG has delivered a solid FFO CAGR of 3.8% despite the fears of malls going out of fashion and factoring in the COVID-19 period, in which many locations were forced to shut down.
By looking at the most recent data, we can see that SPG's operations remain resilient and reveal a continued growth potential. For example, the portfolio NOI has increased by 3.8% on a YTD basis. The portfolio occupancy, as of Q2, 2023, stood at 94.7% compared to 93.9% at Q2, 2022.
In fact, at the time of Q2, 2023 issuance, SPG declared a quarterly dividend of $1.90 for the third quarter of 2023, increasing it by 8.6% year-over-year.
Part of the SPG's long-term success has been its balance sheet. Currently, SPG's balance sheet continues to remain strong with an upper investment grade credit rating of A-/A3. This comes with multiple benefits such as access to cheaper and more flexible financing sources, brings down the WACC to fund transactions at more attractive spreads, and makes the overall business operations more resilient.
Plus, as of Q2, 2023, SPG had ~ $8.8 billion of liquidity from which $1.4 billion was in the form of cash. The total liquidity accounts for ~20% of the total market cap allowing SPG to fund sizeable acquisitions when opportunistic situations arise as well as safely refinance the forthcoming debt maturities.
Investors have to also factor in the size of internal cash flows, which remain at the Company level undistributed due to a very conservative FFO payout (i.e., 60%). This in combination with a solid organic growth and the fortress balance sheet provide great tailwinds for SPG to protect its investors from rising interest costs (via deleveraging) or to fund accretive M&A deals yielding above the financing costs.
The dividend outlook and its growth prospects are favourable for investors, who want to enjoy predictable and growing quarterly dividends.
Bottom line
This is not the right environment for dividend-seeking investors to carry a notable exposure towards passive indices as the yield associated with these vehicles tends to be below risk free rate alternatives.
To capture more attractive cash flows, investors have to cherry pick specific securities paying close attention to the underlying financial risk.
GMRE and SPG are solid names that not only offer current income above T-bills or 10 year Treasury notes, but also come along with great cash flow stability and growth component.
For further details see:
Replacing T-Bills With 2 Higher Yielding REITs Without Sacrificing Stability