We don't say, it's cheap today, but it'll be cheaper in six months, so we'll wait. If it's cheap, we buy. If it gets cheaper and we conclude the thesis is still intact, we buy more. We're more afraid of missing a bargain-priced opportunity than we are of starting to buy a good thing too early. No one really knows whether something will get cheaper in the days and weeks ahead - that's a matter of predicting investor psychology, which is somewhere between challenging and impossible. We feel we're much more likely to correctly gauge the value of individual assets.
--Howard Marks
That quote from legendary investor Howard Marks sums up my view of publicly traded real estate investment trusts ("REITs") right now.
No matter which real estate index you use, whether the iShares US Real Estate ETF (IYR), the Vanguard Real Estate ETF (VNQ), the SPDR Real Estate Sector ETF (XLRE), or some other broad-based real estate ETF, they've all dropped by about 30% since their early 2022 peak.
More than a few of the highest quality, best managed REITs have sold off even more than the broad index average.
As Howard Marks might say, maybe they will be cheaper in a few months or half a year, or maybe they'll be less cheap. I don't know. But I know they are cheap today.
Thus, the more high-quality, investment grade-rated REITs drop, the more I buy.
This might be depressing for some investors. For me, it's exciting.
For investors with a long-term outlook, and especially dividend growth investors like me, I would argue that there is no stock sector more attractively valued or opportunistic for capital allocation today than REITs.
Below, allow me to first demonstrate that REITs are indeed cheap and appear poised for a glorious 2024 rebound.
Then let me preempt a lot of comments by explaining why I'm not buying investor favorite Realty Income (O) -- and why I don't own it at all anymore.
After that, I'll highlight 6 of my favorite highly discounted blue-chip REITs to buy today. But I won't spend much time on this because I've covered all of these before in greater detail.
Yes, REITs Are Cheap
Some keen investors say that REITs aren't really cheap right now, because the market has mechanically marked down their valuations as interest rates have risen.
I say REITs are cheap because:
- Interest rates are highly unlikely to plateau at their current level or go significantly higher from here -- at least not for very long. Higher interest expenses will eventually weaken the economy, which will cause the Fed to lower interest rates due to rising unemployment or falling inflation or both.
- The average REIT balance sheet is still near its strongest level in decades with a leverage ratio of about 30%. If there is going to be a debt-related commercial real estate crash, it will hit higher leveraged private CRE owners long before it hits the average REIT.
- REIT fundamentals remain strong for virtually all sectors, with the notable exception of office buildings.
- Investor sentiment about REITs is significantly worse than it is for other defensive, relatively high debt stock sectors.
On that last point about sentiment, consider the performance of other defensive sectors that are known for their similar uses of debt, such as utilities (XLU) and consumer staples (XLP). Real estate hasn't just underperformed utilities and consumer staples by a little bit. The underperformance has been huge.
Considering that, according to NAREIT, REITs' total funds from operations reached an all-time high in Q2 2023, I think it is safe to say that the magnitude of this REIT selloff compared to utilities and consumer staples is due to weak sentiment, not weak fundamentals.
Comparing global REIT valuations to those of the broader stock market gives an even starker view of their cheapness.
Using the broadly applicable enterprise value to EBITDA metric, REITs are as cheap relative to the equity market as they were at the depths of the Great Financial Crisis in 2008-2009.
But certainly CRE is in for more pain ahead as higher interest rates take their toll and artificially high demand from COVID-era stimulus continues to fade. That is the view of billionaire real estate investor Jeff Greene.
But REITs are a different story, because REITs are publicly traded stocks. And for public stocks, the market is forward-looking. As I explained in "Billionaire Commercial Real Estate Investor Says 'The Worst Is Yet To Come'":
Why in the world would REITs be an opportunistic buy today in the face of this?
Answer: Because REIT prices are forward-looking and front-run future pain, while the market prices of real estate properties themselves lag real-time increases in interest rates and economic weakness.
I showed some charts in that article demonstrating this point, but here is one more:
Notice that as REIT stock prices were dropping in the first three quarters of 2022, private real estate valuations kept rising. Then as private RE values began sliding in Q4 2022, public REIT prices held steady or even began to slightly rebound.
Personally, I wouldn't call this a rebound. Instead, REIT shares bounced slightly off their October 2022 lows and have been rangebound at ~30% below their early 2022 high.
But interest rates have still been rising, so you wouldn't expect REITs to begin rebounding yet.
As this chart shows, REITs perform poorly during periods of rising long-term interest rates, such as we are in right now. They perform even more poorly relative to non-REIT equities. But in the 12 months after long-term interest rates reach their peak, REITs have historically soared, outperforming non-REIT equities.
Some other smart investors will say, "Wait, if interest rates are coming down because the economy is weakening and falling into recession, won't that hurt REITs even more?"
I would argue here that investors are still suffering from the burn of the Great Financial Crisis in 2008-2009, when REITs got absolutely crushed. But this was not an average recession. It was the most severe economic crash since the Great Depression, which is why it gets to have "Great" in its name.
Not only this, but the GFC also resulted in ultra-low investor sentiment about real estate generally, much the same as we are suffering today.
If instead you look at the performance of REITs through the early 2000s recession, you'll find that the average REIT stock price slid in the late 1990s into 2000 as Dotcom mania abounded and interest rates rose and then proceeded to rise right through the recession in 2001.
While I don't have a crystal ball, I am betting that if we get a garden-variety recession in 2024 that results in lower interest rates, REIT stocks will rebound right through the recession.
If interest rates are the main reason REITs have sold off, why wouldn't they also be the main reason they rebound?
Why I'm Not Buying Realty Income (O)
With all of the above said, not all REITs are created equal, and there are some names that do not look like good buys, even after selling off.
An example of that is O.
My argument isn't that you're likely to lose money buying O today. Nor that O's monthly dividend is unsafe. It's that there are far better REIT buying opportunities out there.
Let me give you three quick reasons why I'm not buying this venerable, A3/A- rated REIT:
- O's portfolio is gargantuan, which will make AFFO growth much harder going forward. The REIT owns almost $50 billion in real estate and has to buy $5 billion+ in new properties every year just to generate low single-digit AFFO growth.
- During the pandemic years, O was buying net lease properties at extremely low cap rates (investment yields) and with minimal (~1%) annual rent escalations. In 2021, for example, O's weighted average initial investment cap rate for the year was 5.5%. That is lower than the interest rate on O's credit facility of 5.6% (as of June 30th, before the last Fed rate hike), and it is lower than the average effective yield on A-rated corporate bonds today.
- Unlike some REITs with little to no debt maturing over the next few years, O has a steady slate of debt maturities to refinance (at higher interest rates) next year and the year after.
I'm not saying this will devastate O, but it will be a headwind. I think investors will be disappointed with O's growth going forward. That's why I'm not buying it today.
But if you're buying for that ~5.7%-yielding monthly dividend and are okay with some snail's pace dividend growth, then I'm not going to tell you not to buy it.
6 Opportunistic Blue-Chip REIT Buys Today
To be clear, there are lots of undervalued REITs right now. You could throw a dart from across the room at a list of REITs, and I'm sure you'd hit an undervalued name.
But opportunities to buy best-in-class, blue-chip REITs at a discount don't come often. That's why I prefer to go quality hunting rather than value hunting right now.
Here are six of my favorites, all of which boast investment grade credit ratings and relatively low-leveraged balance sheets:
- Agree Realty Corporation (ADC) -- A net lease REIT that concentrates exclusively on the nation's largest and strongest retailers, such as Walmart (WMT), Dollar General (DG), Tractor Supply Co. (TSCO), and T.J. Maxx (TJX). It is like Realty Income, only smaller in size, with a better portfolio, lower debt levels, and almost no debt maturities until 2028. Like Realty Income, ADC sports a monthly dividend payout schedule.
- Alexandria Real Estate Equities (ARE) -- The only pure-play life science REIT that owns and develops many of the most desirable, state-of-the-art, well-located innovation clusters in the nation. These aren't traditional office buildings. The specialized lab spaces within them ensure that R&D work cannot be carried out remotely. ARE has a weighted average debt maturity over 13 years and no debt maturities until 2025.
- Crown Castle (CCI) -- This industry leading telecommunications infrastructure provider boasts perhaps the largest and most extensive network in the nation, giving it massive scale advantages. Right now, one-time lease cancellations from the T-Mobile (TMUS)-Sprint merger are dragging down the growth rate to the low single-digits, but management remain confident they can and will return to 5% organic revenue growth and 7-8% dividend growth.
- Extra Space Storage (EXR) -- After acquiring Life Storage (LSI), EXR is now the largest self-storage landlord/operator in the US, overtaking Public Storage (PSA) for the top spot. After the boom years during the pandemic, storage has slowed down considerably as people aren't moving or buying houses as much. But American self-storage isn't dead. People will continue to accumulate and store stuff. Plus, when considering extensions, EXR has no debt maturities until 2025.
- W.P. Carey (WPC) -- WPC has been around for half a century and built a huge, multicontinental portfolio of single-tenant net lease properties with attractive lease terms such as CPI-based rent escalations. While the REIT has a lot of debt maturities to refinance next year, its 3%+ rent escalations should offset increased interest expenses. Slow and steady wins the race for this 6.8% yielder.
- Rexford Industrial Realty (REXR) -- This REIT focuses exclusively on infill (within city limits) industrial real estate in the extremely supply-constrained Southern California market. Historically, despite population growth in this region, industrial real estate supply has shrunk as industrial space is redeveloped into other uses. This has resulted in high prices and even higher rent growth rates for these scarce properties. Hence REXR's 50%+ rent growth over the last few years. While 22% of REXR's total debt matures in 2024, total debt to EV is only 16% while net debt to EBITDA is only 3.7x for the REIT.
The two net lease REITs (ADC and WPC) have outperformed VNQ since the beginning of 2022, but year-to-date, all 6 of these blue-chip REITs have sold off more than the broad real estate index.
I've pitched these blue-chip REITs as great buys multiple times over the last few months. See, for example:
- Bloodshed On REIT Street: 5 High-Quality Landlords I'm Buying For The Long Haul
- REIT Meltdown: 3 Rarely Discounted Buying Opportunities
They were cheap then, and to the extent that they've fallen further since then, they're even cheaper now.
My long-term investment thesis has not changed or eroded for any of them.
Therefore, the more they drop, the more I buy.
Bottom Line
There's no need to overcomplicate investing. There are a few simple steps to follow:
- Do your due diligence. Understand what you're interested in buying.
- Seek out the bear case and gain a solid grasp of the risks.
- Exclude stocks or sectors that you don't understand very well.
- Buy the stocks that fit your investment criteria and about which you have a solid long-term investment thesis.
- If the stock price drops and you're still confident in the investment thesis, keep buying.
Candidly, REITs have been cheap in my view for about a year now. Some of them have been getting cheaper and cheaper, despite my best attempts to rally the troops here on Seeking Alpha.
That's okay, because I am confident in the individual REITs I'm buying, and I'm also confident that neither investor sentiment nor the interest rate environment will be this bad for REITs forever.
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