Summary
- Learning valuable lessons doesn’t have to be dull and boring.
- And even if it does, I’d rather have that than repeat some of my past investing pitfalls.
- REITs have performed extremely well when rate-hiking cycles end.
I'm old enough to have lived through multiple economic crises, including several recessions and now a global pandemic. Without a doubt, the Great Recession impacted me the most.
That was when I lost just about everything I owned and was forced to transition into a whole new career.
Turns out, though, being a Wall Street analyst has worked out pretty well for me. Twelve years later, here I am as the #1 writer on Seeking Alpha with over 107,000 followers.
As they say, time flies when you're having fun.
I mean that. I do have fun with all of you on this website, and I hope you can say the same. Learning valuable lessons doesn't have to be dull and boring. And even if it does, I'd rather have that than repeat some of my past investing pitfalls.
You may remember the Doobie Brothers classic " What a Fool Believes. " It starts out like this:
He came from somewhere back in her long ago. The sentimental fool don't see. Tryin' hard to recreate. What had yet to be created once in her life.
The song is admittedly somewhat ambiguous in what it's trying to say. But I think he was trying to recount a lovesick relationship. A fantasy of sorts.
Like many songs in the '70s era, lead singer Michael McDonald may have been telling the world that he was once madly in love with a girl who never existed. That he was chasing a mirage. That only a fool would believe such a thing could be real.
That's why I picked the title of this article, "What a Fool Believes." Contrary to what some people will automatically assume, it isn't to make fun of you. It's to hook you into reading the article, which could help you navigate misconceptions related to real estate investment trusts ("REITs") and rising interest rates.
Because once you understand the truth about them, you're in a much better position to make money.
No Mirage, Just Math
Believe it or not…
REITs have entered the economic slowdown in relatively healthy positions due to favorable supply-demand dynamics amid tight supply. As Cohen & Steers points out:
"A key difference between this cycle and previous downturns is that real estate supply is likely to remain lower for longer. We expect inflation to decline but to remain elevated until at least the end of 2023.
"Higher costs for land, materials, and labor have increased replacement costs, reducing the potential profits of development and raising the economic barriers to new supply and reducing potential competition for existing properties."
Remember that it's the durable and reliable cash flows that provide REITs with their defensiveness relative to other asset classes - especially equities. REITs offer the possibility of stable earnings due to limited supply, contractual leases, high operating margins, and low labor intensity.
To combat inflation, the Federal Reserve has been engaged in one of its most aggressive rate-hiking cycles ever. This included the announcement of a 0.25% rate hike this week - to a range of 4.5% to 4.75% - at the conclusion of its two-day policy meeting.
Of course, this signals that inflation is coming down, as hoped, and the Fed will likely stop hiking the federal funds rate sooner rather than later. Risk assets heard the message loud and clear and turned even more bullish than they were heading into the conference.
Returning to Cohen & Steers, it believes "the futures market indicates the overnight lending rate will reach a terminal point close to 5% by June 2023."
Periods when both growth and yields are down indicates a more "stagnationary" environment. And, yes, times like that have represented a significant tailwind to REITs. On average, they've declined 8.8% in periods when growth is down but yields are up.
By contrast, REITs have climbed 18%, on average during periods when both growth and yields are down - representing a 27% swing, on average, when the transition occurred.
Importantly, REITs have performed extremely well when rate-hiking cycles end. In other words, when the Fed stops raising rates, there's been a historically critical inflection point - averaging 15.8% gains in the first six months afterward.
That's why REITs rallied more than 7% in one day (on November 10) on the news that inflation - as measured by the Consumer Price Index, or CPI - had fallen to 7.7% in October.
They rallied again 1.4% on December 13 after inflation fell again to 7.1% year-over-year in November.
And REITs have continued to outperform year-to-date, up 11%:
Back in 2008-2009, when I was still digging my finances out of the gutter they'd fallen into, I wasn't in any position to load up on REITs. But I am now.
Given what I've seen over my 30+ years of experience and what I'm seeing now, I'm beginning to move more cash into REITs.
Our view is that we're entering a mild recession phase that should last a few months. However, Mr. Market has priced in a much more severe recession against this backdrop.
Although past performance is not an indicator of future results, we stand by the fact that REITs have performed remarkably well after periods of downturns.
Realty Income Corporation ( O )
Realty Income is a real estate investment trust that owns free-standing, single tenant properties that are leased on a triple net basis. Due to the structure of their leases, the tenant is responsible for most of the property expenses including taxes, insurance and maintenance of the property.
One thing to note that applies to all triple net leases REITs is that they can comfortably pay out a higher percentage of their funds from operations ("FFO") as they have little in the way of capital expenditures when compared to REITs with standard lease agreements.
To illustrate this, using operating cash flow as a proxy for FFO, capital expenditures came in at $19.1 million vs $1.3 billion in cash flows for 2021, or put another way capital expenditures totaled 1.4% of cash flow from operations in 2021.
Realty Income is the king of triple net lease REITs, with over 11,700 properties in all 50 states and a growing international presence with properties in the UK and Spain.
Along with their geographic diversification, Realty Income has over 1,100 clients spread across 79 different industries. This diversity mitigates issues that may arise from a single tenant, industry, or region and provides stability for their earnings and monthly dividends.
Among their top 20 tenants includes well-known names like Walgreens, 7-Eleven, Dollar General, Walmart, Sainsbury's and FedEx. Realty Income's top industries include Grocery Marts, Convenience Stores, Dollar Stores and Quick Service Restaurants.
Additionally, while Realty Income is primarily in the retail space, they have some diversification by property type with 13.9% of contractual rent coming from industrial properties.
And then there's the dividend. Realty Income is a Dividend Aristocrat with 27 consecutive years of dividend increases. They have paid 628 monthly dividends with 100 consecutive quarterly increases for a compound annual dividend growth rate of 4.4% since their public listing in 1994.
Realty income has been able to support their rising dividend with stable and reliable growth in their earnings. They have delivered positive AFFO (Adjusted FFO) growth in 25 out of 26 years for a median AFFO growth rate of 5.1% since 1996.
Realty Income has an A- credit rating and a strong balance sheet with 2.5 billion in liquidity, a Net Debt to Adjusted EBITDAre of 5.2x and a 5.5x Fixed Charge Coverage Ratio. 95% of their debt is unsecured and 88% is fixed rate. They have a weighted average term to maturity of 6.3 years with no major maturities due until 2024.
Currently, Realty Income is trading at a blended P/FFO of 16.9x which is slightly under their normal P/FFO of 17.51x. They pay a dividend yield of 4.39%, which is well covered with an expected AFFO payout ratio of 76.17% in 2022.
Realty Income is a high quality and consistently dependable company trading at a slight discount with a healthy yield. At iREIT we rate Realty Income a BUY.
Digital Realty Trust, Inc. ( DLR )
Digital Realty is a REIT that owns data centers around the globe. In all, they own over 300 data centers across more than 25 countries on 6 continents.
Data centers are properties that house servers and require very specialized layouts and systems to manage large amounts of electricity, control humidity and internal temperatures, and contain multiple layers of security to prevent any possible data breach.
Data centers are essential to e-commerce as they receive and process the information coming in from online orders. This is an oversimplification, but essentially when an order is placed online, that signal is sent to cell towers which then transmits the information to data centers which organize and route the information to logistical centers for online fulfillment. That is why we refer to data centers as part of the REIT "e-commerce trifecta."
Digital Realty is one of the largest data center companies in the world with over 4,000 customers in 50 metropolitan regions and have over 188,000 cross connections between servers.
Digital Realty has had steady growth in its funds from operations, averaging a growth rate of 4.04% since 2014.
It's also had consistent dividend growth with 17 consecutive years of increases at a compound annual growth rate of 10% since 2005. Currently DLR has a 4.20% dividend yield that is secure with an expected AFFO payout ratio of 77.46% in 2022.
Digital Realty has a good amount of liquidity at their disposal. As of the end of the third quarter 2022, DLR had $177.0 million in cash and cash equivalents and as of November 2022 they had roughly $1.1 billion available to them under their revolving credit facility.
DLR has a strong Fixed Charge Coverage ratio of 5.5x and a reasonable Net Debt to Adjusted EBITDA of 6.7x. Their debt is 80% fixed rate with a weighted average to maturity of 5.4 years with no major maturities coming due until 2024.
Currently DLR is trading in line with their normal P/FFO ratio with a blended P/FFO multiple of 17.24x. Digital Realty should be able to continue its growth in Funds from Operations and dividend payments in the years ahead with the e-commerce trend that is currently underway. At iREIT we rate Digital Realty a STRONG Buy.
Healthcare Realty Trust Incorporated ( HR )
Healthcare Realty is a real estate investment trust in the healthcare sector that specializes in Medical Office Buildings ("MOB"). HR went public in 1993 with a $135 million initial portfolio consisting of 21 healthcare facilities.
In 2022 Healthcare Realty merged with Healthcare Trust of America to become the largest MOB REIT in the U.S. and as of the third quarter in 2022 HR's portfolio consisted of 728 properties in 35 states covering 42.6 million square feet.
Over the last 25 years HR has developed connections throughout the country with leading health systems and has built up on-campus real estate which is critical to the physician-hospital relationship. Most of HR's properties are either on campus or adjacent to these health systems and provide outpatient services, cancer treatment and house physician groups.
Funds from Operations has seen modest growth since 2014, with a FFO growth rate of 2.87%.
For the full year 2022, analyst project FFO to come in at $1.66 per share, down from $1.75 in 2021. FFO is projected to decrease again in 2023 before returning to positive growth in 2024. Healthcare Realty is set to report fourth quarter results for 2022 on March 1, 2023.
Like their Funds from Operations growth rate, the dividend growth since 2014 has been modest with a compound annual growth rate of 1.51%.
The AFFO (Adjusted FFO) payout ratio expected in 2022 is 474.75%, but that is distorted by a special dividend paid in July 2022 in connection with the HR / HTA merger.
However, even after accounting for the special dividend, Healthcare Realty's AFFO payout ratio has been high in recent years. In 2021, the AFFO payout ratio was 100.39% and came in at 95.83% in 2020.
For 2022, after removing the special dividend, the expected AFFO payout is 106.82%. This is something to keep an eye on. If the analysts' projections hold up, the payout ratio should improve in 2023 with estimated AFFO of $1.32 per share with a dividend rate of $1.25.
Healthcare Realty has a BBB credit rating and a reasonable debt level with a Net Debt to Adjusted EBITDA of 6.3x. HR has a good amount of liquidity with $1.3 billion available on its credit facility and $57.6 million in cash as of September 30, 2022.
Currently HR has a dividend yield of 6.54% and is trading at a P/FFO multiple of 13.13x, which compares favorably to its normal P/FFO multiple of 17.38x.
Although HR has not historically been a high-growth REIT, it pays a high yield and is heavily discounted when compared to its normal FFO multiple. We rate Healthcare Realty a Spec BUY.
Always Remember
One of our portfolios at iREIT on Alpha - the high yield portfolio - is performing extremely well. Since inception (last August 2022) shares have returned +10.5% and the top performers include:
- Realty Income +21.4%
- Blackstone ( BX ) +18.2%
- Simon Property ( SPG ) +17.9%
- Boston Properties ( BXP ) +17.1%
- STAG Industrial ( STAG ) +15.5%
None of the REITs in the portfolio has generated negative returns to date, and it's crushing the S&P 500 (SP500) and Mortgage REITs ( MORT ).
As I said earlier, REITs have performed extremely well when rate-hiking cycles end - when the Fed stops raising rates, there's been a historically critical inflection point - averaging 15.8% gains in the first six months afterward.
Of course, nobody has a crystal ball, and there's no way that I can assure you that REITs will return another 16% when the Fed stops raising rates.
However, what I do know is that by utilizing fundamental analysis, with an emphasis on valuation, the investor can gain an edge over the market timer.
"Those of us that live by looking in a crystal ball learn to eat a lot of broken glass." Peter Grandich.
Benjamin Graham spent much of his career trying to devise a good formula for when to get into -- and out of -- the stock market. All formulas, he concluded, failed." As he concluded (emphasis added):
"You are neither right nor wrong because the crowd disagrees with you . You are right because your data and reasoning are right."
For further details see:
What A Fool Believes