2023-06-06 08:05:00 ET
Summary
- Many investors are buying Treasuries instead of REITs.
- I believe that this is a mistake and explain why.
- I highlight one of my favorite opportunities to buy today.
A lot of investors are now pulling their capital out of REITs ( VNQ ) in order to buy Treasuries ( IEF ) instead.
The reason why is quite simple.
Treasury yields have reached a multi-year high, offering yields above 5% on the short end of the curve:
REITs and other stocks pay lower yields on average and are perceived to be a lot riskier in today's environment.
Why would buy a 4.2% yielding REIT like Alexandria Real Estate ( ARE ) when you could buy 5.5% yielding treasuries instead, especially as we potentially approach a recession and face more interest rate hikes?
That's what many of you have been asking me lately.
It is a fair concern, but the answer is pretty simple: REITs should pummel Treasuries in the long run.
The long-term returns of short-term treasuries are only a function of their current yield.
Treasury yield = your total return
But the long-term returns of REITs are a function of their yield, their growth prospects, their valuation, and their upside potential.
Dividend yield + FFO per share growth + upside = total return
Let's look at the example of Alexandria Real Estate since we mentioned previously.
Dividend yield:
It pays a 4.2% dividend yield. That's the first component of its expected total returns.
FFO per share growth:
Then comes its growth. Alexandria owns life science buildings that are today experiencing rapid rent growth. It has been able to hike the rents of its expiring leases by 20%+ over the past years, and then on top of that, its current leases have 3% contractual annual rent hikes:
Alexandria Real Estate
Interest expense is rising a bit as well and that needs to be taken into account, but the impact is not significant because Alexandria uses little leverage with a 30% LTV and has long debt maturities at 13 years on average.
As such, it is expected to grow its cash flow by roughly 5% annually in the coming years. That's actually below average for Alexandria, reflecting the impact of today's difficult environment.
So here is our total return calculation so far:
4.2% dividend yield + 5% FFO per share growth = 9.2% total return.
That's assuming that the valuation multiple of the company remains intact. (If its FFO per share rises by 5%, but its valuation multiple remains intact, then its share price would need to rise by 5% as well.)
Upside:
Then comes the upside from valuation expansion.
The REIT's valuation multiple is today exceptionally low because its share price has crashed over the past year along with other REITs. The market is a forward-looking machine and so all the fears of rising interest rates, recession, banking crisis, etc. have caused Alexandria's share price to crash even as its cash flow kept on rising:
Alexandria's business isn't heavily impacted by any of these risk factors. In fact, the company just announced another dividend hike a few days ago.
But it has still hurt its market sentiment and as a result, the company is now priced at an exceptionally low valuation of 13x FFO and an estimated 35% discount to its net asset value.
This is an unusually low valuation that won't last.
The only reason why the valuation is so low is that the market is today focusing on the risk of rising interest rates and a recession, but as soon as the narrative changes, the company's valuation will likely recover.
Just to return to its NAV, the share price would need to rise by over 50%. Even if you are more conservative, and you expect just ~30% upside over a 3-year period - that's still very significant.
So here's the total return calculation:
4.2% dividend yield + 5% FFO per share growth + ~10% annual upside from multiple expansion = 19.2% total annual return.
So here you start to understand why I prefer to buy REITs than Treasuries.
I think that REITs will pummel the returns of Treasuries in the long run.
Of course, I cannot predict how REITs will do over the short run. No one can. But over a multi-year time period, I would expect them to generate very attractive returns because of how cheap they have gotten.
The last time REITs were so cheap was following the pandemic crash of 2020 and investors quickly doubled their money thereafter:
Buying real estate at a steep discount is a no-brainer if you ask me.
For further details see:
Why REITs Should Pummel Treasuries