By: Justin Holden
While the S&P 500 continues to be grossly overvalued as we get towards the back-end of this 9+ year bull run, investors are finding it increasingly difficult to find value and buy securities at an adequate margin of safety. However, real estate investment trusts (or REITS for short) are currently being beaten down in price due to multiple factors. For long-term investors, now is the time to take notice and monitor the sector’s highest quality companies. In the event of further price declines for this sector, which would be a likely event for the remainder of 2018, we could see blue-chip REITS at bargain prices.
For novice investors who are completely unfamiliar with REITS, these companies essentially make money through real-estate related investments. There are actually two primary classifications for REITS. Equity REITS own and operate physical real estate, often times renting out their facilities to commercial and/or residential tenants and generating revenues off the rent that they charge those tenants. Mortgage REITS (mREITS) tend to be a bit more complex in their operations since they primarily generate income by collecting interest on mortgage backed securities and related investments. My preference between the two categories is for equity REITS. To me, equity REITS are easier to understand and also safer because you’re investing in companies that own a portfolio of physical real estate properties, as opposed to investing in companies that deal with debt and paper assets.
I’ll also point out that there are some key distinctions to be made between REITS and common stocks. In order for a company to qualify for being listed as a publicly traded REIT, it must, among other things, pay out at least 90% of it’s taxable income to shareholders in the form of dividends. Another key distinction is in how you figure out valuations. For common stocks, investors often look to the price earnings (P/E) ratio to determine if the security is overvalued, undervalued, or fairly priced. But because REITS are allowed under the current tax laws to claim depreciation on properties that in reality are actually appreciating in value, this non-cash depreciation expense will artificially deflate the company’s earnings or net income on paper. Because of this, we should use a price to funds from operations (P/FFO) ratio when discussing REIT valuations.
Now that we have covered some of the basics on REITS, let me explain to you some of the factors that are currently driving down valuations for this sector. The market seems to be bracing itself for increased interest rates, which makes borrowing money more costly. This will impact all companies to a certain degree, but REITS in particular seem sensitive to interest rate changes. Perhaps this is because some of them rely heavily on the ability to take on debt in order to purchase more properties and thus fuel growth. But another huge factor in the REIT sector selloff has been the perceived downfall of brick and mortar retail stores. There are a number of REITS that lease properties to commercial tenants. When those commercial tenants see their business fall on hard times, the risk is being unable to pay rent and closing stores. The more stores that close, the more empty properties a REIT has in it’s portfolio generating zero in rent revenue until a replacement tenant is found. The retail sector is really hurting right now due to powerful online competitors such as Amazon. The most recent example is Toys R Us, which is closing stores all across the country and appears to be headed for bankruptcy.
But as with any market selloff, the fears tend to be overblown. When we take a long-term perspective, it’s hard to see a future without brick and mortar retail stores. There will be enough people that want to try on clothing before making a purchase, or enjoy the experience of going out to do their shopping. It is difficult to envision that totally going away. So unless you’re projecting that Amazon’s long-term outlook is taking over the world, you shouldn’t be too concerned about the downturn in retail. As for the REIT sector selloff, we are seeing those equity REITS with high exposure to brick and mortar retail tenants getting hit hardest. But even other classifications of REITS are going down in price. This truly is the time to be greedy while others are fearful, and consider buying REITS on the dip.
Now sure, you could just buy a diverse fund focused on the sector like Vanguard Real Estate ETF (VNQ), but then you’ll be buying into some crap securities to go along with the truly high quality REITS, not to mention paying management fees for the fund via an expense ratio. My recommendation would be to monitor the following list of individual REITS. I have hand picked them because they are, in my view, the highest quality large-cap REITS for the entire sector and have a great chance to outperform over the long-term while allowing you to sleep well at night. Just make sure that if you buy any of these securities, you do your own due diligence beforehand and buy on the dip, thus locking in a reasonable margin of safety. Because as with any other type of securities investing, the goal is to buy low and sell high.
Justin’s REIT Watch List:
- American Campus Communities, Inc. (ACC)
- Digital Realty Trust, Inc. (DLR)
- Federal Realty Investment Trust (FRT)
- Hannon Armstrong Sustainable Infrastructure Capital (HASI)
- Kimco Realty Corporation (KIM)
- LTC Properties, Inc. (LTC)
- Realty Income Corporation (O)
- Regency Centers Corporation (REG)
- Retail Opportunity Investments Corp. (ROIC)
- Tanger Factory Outlet Centers, Inc. (SKT)
- Simon Property Group, Inc. (SPG)
- STORE Capital (STOR)
- Ventas, Inc. (VTR)
- W.P. Carey, Inc. (WPC)
Disclosure Statement: Justin currently owns shares in Kimco Realty Corporation (KIM). Justin is not a licensed financial analyst or financial planner. Please do your own due diligence and research before making investment decisions.