Stocks/International

Lyn Alden Schwartzer

Filtering Through the Noise to Find Value

A Tour Through REITville: Unexciting Forward Returns

The real estate sector outperformed the S&P 500 by over 3% in March:

Looking back over the first three months of the year, the dividend yield for the Vanguard Real Estate ETF (VNQ) was over 4.8% at the start of January, but is now only 3.96% thanks to higher valuations:  

Even during some down days in the wider market, REITs went up. With the bond market forcing the Fed to turn more dovish, and 10-year treasuries yielding only 2.4%, many yield-hungry investors have turned to REITs in order to get a decent yield.

Going forward over the long-term, that means the real estate sector likely offers lower returns from this price level. But if we see a correction this spring or another point in 2019 or 2020, it may open up some more buying opportunities.

I’ll outline a few examples of REITs in this article.

Realty Income (O)

A very popular REIT among dividend investors is Realty Income Corp (O). It is renowned for its conservative triple net leasing model, consistent outperformance over decades, a strong credit rating of A-by S&P, and the fact that it pays dividends every month rather than quarterly. 

Unfortunately, its popularity has recently pushed it to overvalued levels like we saw in 2016:

Chart Source: F.A.S.T Graphs (black line = current stock price, blue line = average P/FFO level, white line = dividends)

Realty Income’s dividend yield is now a mediocre 3.7%. With over 80% of their real estate portfolio in the retail industry, growth is hard to find these days. Analysts expect about 4-5% growth going forward, so assuming constant valuation and an optimistic retail environment that doesn’t result in vacancies, the long-term forward returns from Realty Income are in the ballpark of 7.7%-8.7% annualized. That’s the fairly optimistic case.

In a more bearish scenario, if Realty Income returns to its historical P/FFO multiple, it would see a 25% share price decline just from changes in valuation. Spread over five years, that’s about a -5% annual valuation reduction to offset the 7.7-8.7% positive fundamental returns from the dividend and mild growth. And of course in a more bearish scenario still, the business could fail to grow at 4-5% in a challenging economic environment, further putting downward pressure on returns.

Overall, the risk-reward ratio for the ever-popular Realty Income isn’t very good at the current price level. I'm not touching this one. 

AvalonBay Communities (AVB)

Looking at one of the biggest residential REITs, AvalonBay, the valuation looks better:

Chart Source: F.A.S.T Graphs (black line = current stock price, blue line = average P/FFO level, white line = dividends)

This REIT is one of the largest investors of apartments in the United States, with tens of thousands of units clustered on the coasts. With significant wealth inequality in the United States, and millennials slow to buy homes due in part to substantial student debt that previous generations didn’t have to this degree, apartment landlords have been doing rather well.

AvalonBay’s dividend yield is only 3.0% and expected growth is mediocre at 4-5% per year, but we don’t see clear overvaluation today as we do with Realty Income. Furthermore, AvalonBay has a strong credit rating of A-, and very little leverage for the real estate industry at only 66% debt/equity.

The downside to apartments is that they don’t have a very strong economic moat. The industry is very reliant on a reasonably tight supply/demand situation, and it’s very easy for a company to come in and build more apartments if demand exceeds supply. Lately, there has been a boom in apartment starts.

In my opinion, AvalonBay is not a bad place to park very long-term capital at the current price level, but not very appealing either. It could give high single digit returns for the foreseeable future, when averaged over a 5+ year period. This one is more exciting to pick up under $160 if we see a nice sell-off at some point.

Prologis (PLD)

The industrial subsector of REITs has been hot lately, as online retail companies need warehouses and other logistics assets to hold and transport their products.

Prologis is one of the leaders in this industry, and has a presence around the world including in fast-growing Asia as well as slow-growing Europe.

Fundamentally, Prologis has been performing very well. From 2016 through the end of 2018, Prologis increased revenue, cash flows, and dividends to shareholders while also reducing debt-to-EBITDA from 4.7x down to 4.2x. This should position them well for the next economic downturn.

Its share price is neither clearly overvalued nor giving investors a clear value opportunity:

Chart Source: F.A.S.T Graphs (black line = current stock price, blue line = average P/FFO level, white line = dividends)

The logistics/industrial industry is a lot more cyclical than the residential industry. The stock price of Prologis has largely traded rationally along with its fundamentals. During the global financial crisis, their business was under considerable pressure, but daring buyers a decade ago made over 600% returns on their money since then. This is one to watch on dips.

American Tower (AMT)

Another hot real estate subsector is cell towers. American Tower is the largest landlord for companies like AT&T, Verizon, Sprint, and T-Mobile to provide 4G and 5G coverage over the United States.

American Tower has seen very fast growth over the past several years, but that growth has slowed down recently. Fortunately, the rollout of 5G is good for American Tower because the inherent short-range nature of 5G requires much more numerous towers than 4G. The towers need to be closer to users. Additionally, 5G will be able to connect to more devices, and the Internet of Things (IoT) could get a significant boost in the coming years. Lower latency means watching movies or download things wirelessly is a lot easier, so we should see a continued increase in data usage.

But, like many REITs, American Tower has recently had a big spike up in price, simply due to changing interest rates:

Chart Source: F.A.S.T Graphs (black line = current stock price, blue line = average P/FFO level, white line = dividends)

This puts downward pressure on forward returns, as the dividend yield is lower while growth hasn’t changed.

Ventas (VTR)

Ventas is a blue-chip healthcare REIT. Ever since they spun of their skilled nursing facilities, they have been mostly reliant on private-pay rather than government-pay facilities.

However, much like the supply/demand characteristics of apartments, senior living communities do not have very wide economic moats because it’s easy to build more. There’s a huge demographic trend towards senior living communities due to the retiring baby-boomers, and this has been a tailwind for Ventas, but developers are aware of this trend and have built more than enough to keep up with supply, which puts downward pressure on occupancy and rates.

To offset this, Ventas has been diversifying into a variety of other medical properties including life sciences at top-tier universities. These are wide-moat assets, but expensive.

Ventas has been historically extremely well-managed by long-tenured CEO Debra Cafaro and has dramatically outperformed its closest peers as well as the S&P 500 and the broad REIT universe. The capital allocation skill of Cafaro and her team is consistent. However, pressure on their senior living communities is flattening fundamental expectations over the next few years, while the share price has increased.

Chart Source: F.A.S.T Graphs (black line = current stock price, blue line = average P/FFO level, white line = dividends)

Aside from the sizable and safe 5% dividend yield, there isn’t a lot to be excited by here for the next few years. I am long Ventas, but not buying more at today’s prices and may trim if the price gets too high.

Tanger Factory Outlet Centers (SKT)

If you want to find any potential value in REITville, you likely have to look at companies with bad credit ratings or go digging around in the dark world of retail. But both of these options expose you to the risk of buying value traps.  

If I had to buy one retail REIT, it would probably be Tanger:

Chart Source: F.A.S.T Graphs (black line = current stock price, blue line = average P/FFO level, white line = dividends)

Ultimately I’m not pulling the trigger on this one, but I can see the case for it. The fundamentals have remained relatively flat while the stock price has gone sharply down.

Tanger operates a set of high-quality outlet centers, has very good management, currently sports a decent BBB credit rating, but is operating in a tough environment, continually threatened by the likes of Amazon and other online competition.

The base case is that the fundamentals hum along flat for a while, and the REIT continues to pay out a big 6.7% dividend yield and buy back 2-3% of its shares annually, giving investors 9% or so returns in the face of a flat top line.

The bear case is that fundamentals start to deteriorate, and the stock becomes a value trap. After years of growth, expected forward funds from operation (FFO) growth is basically flat. If this turns sharply down, which it certainly could, all bets are off.

The bull case is that fundamentals not only remain solidly flat, but that the stock price partially reverts to its historical average valuation. Shares historically traded at an average P/FFO ratio of over 16, but are now just above a P/FFO ratio of 8. If the stock merely half-way reverts to a P/FFO ratio of 12, that would be about a 40% price increase from today’s level, along with a 6.7% annual dividend yield.

There’s certain an upside case for Tanger, but plenty of risk as well.

And that sums up what I’m seeing in REITs lately. Their fundamentals, on average, are flat-ish, while higher valuations in blue chip REITs have driven down the average dividend yield, likely resulting in unexciting forward returns. REIT investors seeking higher returns may have to look into the more troubled spaces, which increases risk and uncertainty.

Lyn Alden Schwartzer covers North American stocks and international equity ETFs with a focus on fundamental valuation. Her background is a blend of engineering and finance, and she uses a dispassionate long-term quantitative and qualitative approach to filter through the noise and find value in stocks and markets around the world.
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