Co-produced by David Ksir.
In an effort to fight inflation, the Federal Reserve has raised interest rates significantly over the past year and a half, and this has caused real estate investment trusts aka REITs (VNQ) to drop by nearly 40%:
But during this same time, most REITs actually grew their cash flow by about 10%. As a result, many REITs now trade at extremely low valuations as if they were going out of business. But that couldn’t be further from the truth, as quality REITs, such as the ones I’ll highlight below, have continued to operate as normal, have grown their cash flows, and today have some of their strongest balance sheets ever.
The way I see it is that conservatively financed high-quality properties are here to stay, and buying them at the right valuation is likely to result in very good returns over the long term.
Moreover, I expect the Federal Reserve to cut interest rates sooner rather than later, and this will likely unlock substantial upside for those not afraid to invest when there’s blood in the streets. While I cannot time the market and I don’t know when the Fed will cut interest rates, I do know that 10 years from now, investors will very likely be looking back at today’s prices and wishing they had invested heavily in discounted REITs.
Today, I highlight 5 REITs that I would describe as "once-in-a-decade" buying opportunities.
Alexandria Real Estate Equities, Inc. (ARE)
Alexandria is a unique (sometimes misunderstood) REIT that focuses solely on Life Science properties, which it leases to big pharma and biotech companies. These are the kind of jobs that cannot be done remotely, which puts ARE’s properties in a much better position than traditional office space.
But over the past 18 months, ARE stock has dropped as if it was an office REIT, losing more than half of its value:
Based on the chart, one would think that the company must be facing some serious issues.
But that simply isn't the case.
While leasing has slowed down from the exceptional levels seen in 2021, it remains solid and in line with its 5-year average. Occupancy is also at its highest since 2019 at 95.1%. Moreover, ARE has been releasing its space at very high rent spreads of 30%+, which suggests that most of its current leases are deeply below market and its tenants clearly value the space.
Such high spreads are a direct contradiction of the bear thesis that tenants will want to downsize:
ARE's cash flow will likely keep growing at a mid-to-high-single digit because it enjoys:
- Significant rent spreads that will gradually be realized as leases expire
- Above-average rent escalators of 3%
- A sizeable and mostly pre-leased pipeline of nearly 7 Million sqft of space that will become operational over the next 3 years and increase the overall NOI by double-digits.
In the meantime, the REIT also maintains one of the best balance sheets in the whole sector with a long weighted-average remaining debt term of 13.4 years, 99% of debt fixed-rate, and minimal near-term refinancing risk.
I have no doubt that ARE will grow its cash flow over the next several years, yet the market completely ignores this and has priced ARE at the lowest level since 2009. The stock now trades at just 13x FFO (funds from operations), which is almost 50% below the 10-year average of 24x (average, not peak!)
ARE is a rare opportunity to buy a blue-chip company with a 5%+ dividend yield and the potential for triple-digit upside as its valuation recovers.
Vonovia SE (VNA / OTCPK:VONOY)
Vonovia is a German apartment landlord that owns over half a million residential units, mostly in Germany but also in Sweden and Austria. The company runs an incredibly stable business of renting apartments in markets where renting is the norm and where there’s a chronic undersupply of housing.
This, along with the regulated nature of rents in Vonovia’s markets, results in very high and stable occupancy of 98%, near-perfect rent collections of 99.9%, and very predictable annual rent increases of about 3%.
Moreover, the company has achieved significant scale following the Deutsche Wohnen acquisition, which has resulted in a record-high gross margin of 81%.
But just like ARE, despite great performance on an operational level, the share price has collapsed from $70 per share in late 2021 to just around $20 per share:
The selloff was driven by fears of high leverage and the potential inability to refinance debt maturities as they come due.
But Vonovia has made a lot of progress on this front over the past 6 months. They have closed two major disposals at prices near book value which generated enough liquidity to repay all of their bonds due this year and next year. They’ve also already agreed with the banks to refinance all of their bank loans maturing before 2025 at very reasonable rates of 3.5-4%. Management has already identified another disposal that could help meet the rest of its 2025 debt obligations if rates remain higher for longer.
To set the record straight, it is true that Vonovia has more leverage than its U.S. peers and it will likely hurt its near-term performance. But there’s a clear way out of this, and I think the market has overreacted once again.
I do expect the book value, which currently stands near 50 EUR / share, to come down a bit as Vonovia is forced to revalue their portfolio after each major disposal, but trading at €23 per share, there’s nearly 100% upside potential to even our more conservative NAV estimates. We think that this reward prospect is well worth the risk, especially considering the chronic undersupply of properties in Vonovia’s markets which are likely to result in steady growth going forward.
Realty Income Corporation (O)
O is a REIT that needs little introduction. It has almost a cult-like following because of its exceptional track record:
This is one of the largest REITs out there, and we have previously argued that its large size is a bit of a headwind as it will likely slow down its future growth.
But the good thing is that even with a relatively slow growth rate, O should do fine going forward because its stock now trades at such a low valuation.
Its current FFO multiple is just 12.2x. That's exceptionally low for an A-rated REIT with defensive fundamentals and steady growth prospects.
To see how cheap that is consider the following: at the height of the pandemic when everyone was at home and O’s properties were completely empty, the lowest the stock dipped was 13.2x FFO and it stayed there for about a week. In fact, the only time it traded lower than today was for about 4 months into 2009, when it briefly fell below 10x FFO. Back then, O was far smaller and more heavily leveraged as well. And this history is very relevant because during 2004-2008 interest rates were just as high as they are today:
Once again, I cannot time the market, but over a long-term horizon, I see substantial upside from these levels when the credit cycle turns. Until then, investors will continue to collect a high monthly 6.1% dividend yield which is very likely to keep rising.
BSR REIT (HOM.UN:CA / OTCPK:BSRTF)
BSR REIT is a Canadian-based apartment REIT with properties located in three fast-growing Texan markets. These are Dallas, Houston, and Austin.
Contrary to other apartment REITs in the region, BSR focuses exclusively on B-Class garden communities with low rents under $1,500 per month, which gives the company a major advantage.
Firstly, it results in significantly better rent coverage for BSR’s tenants and this should translate into higher rent collections if we go into a recession. And secondly, it puts the portfolio in a much better position to face the new supply of apartments hitting the market in Texas. The vast majority of new development projects are A-Class properties with rents that are materially higher than those of BSR's properties.
BSR REIT is on track to deliver 7% same-store NOI growth this year and has a strong balance sheet with low leverage of 35% LTV.
Yet, the stock trades at an estimated 45% below the stock’s net asset value, and the management is taking advantage of this by buying back a bunch of stock.
Crown Castle Inc. (CCI)
Crown Castle is a cell tower REIT just like American Tower Corporation (AMT), but unlike its peer, CCI focuses exclusively on the U.S. market.
I like this about CCI because the U.S. market enjoys the greatest barriers to entry in this space, the best contract enforceability, and this should result in more consistent and predictable cash flow growth over the long run:
The REIT is currently experiencing a temporary slowdown in its growth due to the recent merger of two of its major tenants: T-Mobile US (TMUS) and Sprint. It will result in some lease terminations in the next 2 years as the two players consolidate their assets. Moreover, telecommunication providers are currently hesitant to invest significantly in new 5G infrastructure and are focusing on deleveraging instead.
But despite these short-term headwinds, the long-term prospects remain very compelling for the cell tower sector. The consumption of data is expected to grow by 20% annually for the rest of the decade.
As a result, the management sees a clear path to 7-8% annual FFO growth beyond 2025. In fact, they have already contracted most of that growth.
Yet, CCI currently trades at a very low valuation of just 12.2x FFO, which is 45% below its long-term average of 22x. Not only that, but the REIT pays a 7% dividend yield - the highest ever for the company:
Sure, interest rates have increased and the company will face slower growth for the next 2 years, but this is not the end of the world. The company has a strong BBB rated balance sheet and most of its growth post-2025 is already secured.
We believe that as the company's growth rate accelerates back to its historic average, the market will also reprice the stock at a materially higher level, and returning to just 18x FFO would generate substantial upside from here. While you wait, it also helps that you earn a 7% dividend yield.
Bottom Line
Sentiment is at an all-time low in the REIT sector and as a result, there are a lot of bargains.
Times like these, when nobody wants to buy, are very often the exact times when prices are the lowest. Market-beating returns rarely come when everything is sunshine and rainbows.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
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