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Searching for Value in the REIT Rubble

Leave it to the stock market to do the exact opposite of what you expect it to do. Following Donald Trump’s surprise win, stocks have spent the past three weeks pushing higher.

Ironically, given that the President-Elect is a world-renown real estate developer, real estate investment trusts (REITS) have gotten clobbered. REITs as a sector peaked in July, but the selling has continued well past the presidential election.

As I’m writing this, the sector is down nearly 20%… ouch!

Whenever I see a sector flirting with bear-market territory at a time when the rest of the market is hitting new all-time highs, I sit up and take notice. Sometimes it can be the sign of a sector facing deep, long-term problems with no easy solutions. But just as often, it’s a classic market overreaction.

So, as we look at the carnage in REITland, which is it?

Is the market correctly forecasting real estate doom… or is Mr. Market working himself into a stomach ulcer over nothing?

Let’s take a look.

The narrative right now is that the Fed’s pending rate hike is bad news for REITs, as it potentially raises their cost of capital. Adding to this anxiety is the spike in longer-term bond yields. See, higher bond yields hurt REITs in two ways.

To start, it raises their borrowing costs. REITs, as with most real estate investors, tend to borrow a lot of money, and every additional dollar paid in interest is a dollar not kept as profit. But perhaps worse, REITs tend to be priced relative to bonds. So rising bond yields (and falling bond prices) mean rising REIT yields (and falling REIT prices).

This latter point has been a particular worry since investors have come to view REITs as bond substitutes over the past few years. With bond yields too low to be worth considering, investors have been chasing the higher yields of other income sectors, particularly REITs.

Again, that’s the narrative. But is it actually true?

Well, let’s see. The following chart shows the performance of REIT stocks during periods of rising bond yields. The shaded areas represent periods in which 10-year bond yields were rising.

reits
If the narrative you read in the financial press were true, you’d expect REIT stocks to tank every time bond yields had a significant bounce. But that is clearly not the case here. Of the six times since 1981 that we saw bond yields rise by a meaningful amount, REIT prices actually rose in three of them.

With President-Elect Trump pushing for large tax cuts and major new infrastructure spending, there’s a lot of worry in the market right now that outsized budget deficits will cause long-dead inflation to come back with a vengeance.

Don’t bet on it.

Let’s get serious. If large budget deficits were all it took to stoke inflation, then Japan – with the largest budget deficits in the world – would also have the highest inflation in the world. Suffice it to say, it doesn’t. Japan has been fighting deflation, not inflation, for three decades now.

And while I would love to get a tax cut, I don’t see it giving a major jolt to consumer spending. The cohorts most likely to have incomes high enough to benefit – baby boomers and early gen-xers – have already crossed their peak spending years, so any extra cash due to tax cuts is likely to get saved or invested rather than spent.

The generation most likely to actually spend the money – millennials – is already paying close to zero in taxes at its current income levels, so it’s hard to see Trump’s tax plan having a major impact.

So, what’s next for REITs?

I’m betting that we see another repeat of the scenario we had a year ago. Then, as now, bond yields ended the year relatively high, and REITs were under pressure. But when yields started to ease, REITs enjoyed a spectacular rally.

 

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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Rising Bond Yields Smash REITs. What Happens Next?

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Photo credit: clement127

Real estate investment trusts have gotten absolutely crushed over the past three months and particularly since Donald Trump’s surprise victory in the 2016 presidential election. The perception is that Trump’s economic policy will blow out the budget deficit, fuel inflation and send bond yields higher. And as REITs have become proxies for bonds in the low-yield world of recent years, as go bonds, so go REITs.

That’s the consensus view, at any rate. I have my doubts. To start, surging budget deficits do not automatically lead to higher bond yields. If that were true, Japan would have the highest bond yields in the world. Instead, Japanese yields are essentially frozen at 0% and have been for years. Furthermore, the biggest peacetime deficits in history happened during the 2008-2009 meltdown… when bond yields plunged to lows no one dreamed possible before. And all of this depends on Trump getting his budget through a Tea-Party-controlled House of Representatives that ties its entire indentity to reducing the size of the government.

Nevertheless, REITs are taking it on the chin at the moment. This is the third time in four years that this has happened. The first and second, respectively, were after the 2013 Taper Tantrum and as Janet Yellen first raised the Fed Funds rate above zero this time last year. In both previous cases, REITs dropped about 20% in value before recovering to new highs. This time around, REITs are down by a comparable amount… might a repeat rally be in the cards?

I think it’s highly likely. I’ve argued for years that, even at their current low yields, REITs remain attractively priced relative to bonds and most other income investments. And Evercore ISI, writing for Barron’s, was kind enough to work out the numbers for us. Evercore ISI examines REIT prices relative to:

  1. price/net asset value (NAV)
  2. price/adjusted funds from operations (AFFO)
  3. implied cap rates versus 10-year Treasury yields and corporate bond yields
  4. a sensitivity analysis looking at upside/downside scenarios based on implied cap rates and spreads to the 10-year Treasury looking out one year from now.

These were their findings:

Price/NAV: Given the steady decline in REIT prices since early August, REITs are now trading at an 11% discount to our current NAV estimates and a 12% discount to our forward NAVs. This 11% discount is the widest we’ve seen since January 2014 (that’s nearly three years).

Price/AFFO: The sector is trading at 20.2 times AFFO on a forward-12 month basis which is two turns below the sector’s trailing three-year average but slightly less than four turns above the sector’s long-term average which is just shy of 16.5 times. However, when we adjust the AFFO multiple for the lower interest rate environment, a 20 times multiple doesn’t look out of place and in fact using historical spreads (AFFO yields minus 10-year Treasury yield) an AFFO multiple of 20 times would imply a 10-year Treasury yield of 2.65% which is 60 basis points above Wednesday’s closing yield.

Implied cap rates versus 10-year Treasury: The spread Wednesday versus 10-year Treasury yield is 370 basis points and is 53 basis points higher than the long-term average suggesting that REITs are modestly undervalued versus Treasuries or are fairly valued assuming the 10-year Treasury yield reaches 2.5% in the near to intermediate-term.

Implied cap rates versus BAA bond yields: The spread Wednesday is 127 basis point and is wider than the long-term average of 42 basis points and roughly double the spread experienced over the past 24 months. What’s interesting to note is that while the 10-year Treasury yield has backed up 55 basis points since June, the BBA bond yield is only up 10 basis points over the past four months implying that credit spreads have narrowed while the base rate has expanded.

While it’s helpful for investors to look at a snapshot of valuation metrics, we also wanted to provide a more dynamic implied cap analysis which allows two variables to move at the same time. In this exercise, we let Treasury yields and future net operating income (NOI) growth fluctuate within a range while keeping the “spread” constant at 311 basis points which is equal to the long-term average. If an investor assumes that the 10-year Treasury yield will approach say 2.75% in 12 months and the REIT sector could generate NOI growth of say 3% one year from now, then REITs should rise about 5% over the next year.

So in a nutshell, REITs are pretty reasonably priced right now. If you’re bearish, you’re essentially betting that the 10-year Treasury yield is going north of 3% within the next year or that earnings ar about to fall off a cliff. While I suppose either of those outcomes could happen, I wouldn’t bet on it. I would expect REITs to enjoy another solid rally… just as they did the last two times they sold off on yield fears.

 

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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Seritage Growth Properties: Warren Buffett Bought WHAT?

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Leave it to Warren Buffett to keep us guessing. The Oracle of Omaha just reported 8% stake in Seritage Growth Properties (SRG), a REIT spinoff of struggling old-line retailer Sears Holdings (SHLD). SRG owns a portfolio of 266 Sears properties, some of which it owns via joint ventures. But it’s essentially a dumping ground for Sears real estate and a vehicle for Sears Chairman Eddie Lampert to extract as much value as he can from a sinking ship. (I wrote about this earlier this year; see article.)

So, why would Warren Buffett want a piece of SRG? When I saw the news, I legitimately thought it was a joke. I actually had to check the SEC site to verify.

Interestingly, Mr. Buffett is not alone here. Contrarian value investor Bruce Berkowitz had amassed a 10% of the company as of the end of last quarter, though he’s been trimming back recently. Berkowitz has been a large shareholder of Sears Holdings for years. In fact, it’s his single biggest holding. So if he sees value in Sears, it’s not shocking that he would also see value in Sears’ spun-off property portfolio. (I wrote about Berkowitz and his highly-concentrated value portfolio earlier this year; see Seven Masters of the Universe.)

Both Warren Buffett and Bruce Berkowitz have had some high-profile mistakes in recent years. Sears has been a disaster for Berkowitz, and Buffett has lost a fortune in IBM (IBM). But both of these gentlemen have absolutely crushed the market over their careers, so when they make a large new position, it’s worth picking into the details.

First, we should clarify a point on size. Yes, Berkshire Hathaway (BRK.A) now owns 8% of SRG, and Berkowitz’s fund owns 10%. But SRG is a tiny REIT with a market cap of about $1 billion. So Berkshire Hathaway’s position, which had a cost basis of just $70 million, is a tiny drop in the bucket. Berkshire Hathaway has a market cap of well over $300 billion. So while the SRG purchase looks big in the headlines, it’s pretty much pocket change for Warren Buffett, the equivalent of buying a Cherry Coke (Buffett’s favorite…) for the rest of us.

Likewise, while Berkowitz owns 10% of SRG, it only accounts for less than 4% of his portfolio.

Still, might there be some value here? Let’s take a look.

Seritage is a new REIT that only began trading in July, so there is not a lot of history to it. And to date, SRG has yet to pay a dividend, though it has promised to do so before year end.

Looking at the financial results, nothing particularly jumps off the page. “Normalized” funds from operations (“FFO”) last quarter came in at $0.52 per share. Annualizing that, SRG trades at a price/FFO multiple of 19. That’s not particularly cheap though not completely out of line for the industry. It also suggests a dividend yield in the 3%-4% range is doable.

Normally, I’m somewhat skeptical of “specialty” REITs that are spun off from a single large property holder. To start, there is major concentration risk. What if Sears finally goes belly up?

And you have to legitimately ask if a spinoff REIT is truly to be run independently for the benefit of its shareholders or if it is little more than a funding vehicle for the former parent company. For example, might Seritage give Sears preferential treatment with below-market rents? Maybe, maybe not. But questions like these should normally cause a spinoff REIT like SRG to trade at a discount to its more diversified and more independent peers.

That was my initial thought. But I was pleasantly surprised to see that 22% of SRG’s rental income comes from tenants other than Sears. And that number should grow over time, presumably allowing for respectable growth in rents as non-Sears tenants pay market rates.

So while a discount to larger peers like Realty Income (O) would still be warranted, that discount should definitely close with time.

When Eddie Lampert first took control of Sears, we all more or less assumed it was his intention to unlock its real estate value while slowly allowing the retail business to wither and die. It might have all gone according to plan had the 2008 meltdown and Great Recession not hit. But with his launch of SRG earlier this year, it looks like Mr. Lampert is still more or less doing what he had always planned to do. (See Is Sears the Next Berkshire Hathaway.)

I wouldn’t be a buyer of SRG at today’s prices. The shares are up about 15% on the news of Warren Buffett’s position, and I think it’s likely that shares drift back down once the news properly sets in. But SRG might be a REIT to watch. In particular, look for progress in the coming quarters in reducing exposure to Sears Holdings and look for dividend guidance in the next quarterly report.

Disclosures: Long O.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

Photo credit: DonkeyHotey

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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Will the Fed’s Rate Hike Kill REITs?

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The Federal Reserve has spoken, and it’s all pefectly clear now.

Ok, I sincerely hope you realize that I’m joking. Janet Yellen gave us no real insight in her statement this week as to what comes next. We’re left to assume a rate hike will be coming before year end, but Yellen insisted in her comments that, even post lift off, policy would remain “highly accomodative” for as long as inflation remains muted.

I have no Rosetta Stone to translate Fedspeak into English. But Yellen’s words would seem to suggest a “one and done” scenario in which the Fed raises rates by a quarter point or two and then sits on its hands for a while to see what happens.

We’ll see. In the meantime, yield-sensitive assets like REITs continue to get whipsawed as investors handicap the likely move in interest rates. The received wisdom is that Fed tightening will take a wrecking ball to REIT prices, and REITs have been selling off for most of 2015 in anticipation.

But is it true? If interest rates really do rise significantly, will REITs suffer? Let’s take a look at past tightening cycles to see.

The chart below tracks the price performace of the NAREIT All Equity REIT Index going back to the early 1980s and compares it to the Federal Reserve’s targeted Fed funds rate. Periods of extended tightening are highlighted in blue.

Slide1

Note: Past performance no guarantee of future results.

We’ve had five periods of extended tightening since 1981. In three of them, REIT prices did indeed suffer. But in the other two — and keep in mind, that is fully 40% of the total — REIT prices actually did very well. The tightening cycle of the mid-2000s coincided with one of the greatest bull markets in the history of REITs as an asset class.

A few points have to be made here. We only have five observations in our sample, which is far too few to draw strong conclusions. The quants in the room will rightly point out that you need a sample size of at least 30 to draw meaningful conclusions. But this data should at least cast doubt on the received wisdom that rising interest rates automatically mean falling REIT prices.

It’s also worth noting that, the 2008 meltdown notwithstanding, REITs have arguably been in a secular bull market for over thirty years now… a thirty-year period that also happened to correspond with the “great moderation” in inflation and interest rates. We’ve never had interest rates this low for this long, so the historical precedents might not be the most appropriate.

Let’s step away from the Federal Reserve for a second. As long-term income investments, REITs should be less affected by Fed policy and more affected by moves in long-term bond yields. The next chart takes a look at REIT performance during periods of rising bond yields.

REIT Price Performance

Note: Past performance no guarantee of future results.

There really haven’t been too many extended periods of rising 10-year Treasury yields over the past three decades. The dominant trend has been one of falling yields. That said, I found six periods where 10-year yields trended upward for an extended period. Again, the story is ambiguous. In the early-1980s and mid-2000s, REITs did very well during periods of rising bond yields. But in the mid-1980s, early-1990s and late-1990s, REITs performed poorly. And most recently, during the “Taper Tantrum,” REITs performed poorly.

This suggests that rising bond yields would “probably” hurt REITs. Of course, it is by no means certain that we’ll see rising bond yields for a sustained period of time. Bond King Bill Gross said this week in a CNBC interview that a 2.4% yield on the 10-year Treasury was “about right” over the next several years. Gross swings and misses from time to time, but I agree with him here.

Finally, let’s look at REIT valuations by comparing their current dividend yields to the yield to maturity on the 10-year Treasury. The following chart tracks the yield spread between the two. Conventional wisdom says that REITs should yield more than bonds due to their higher risk. But is this actually true in the real world?

Slide3

Note: Past performance no guarantee of future results.

Not exactly. Since the 1990s, REIT yields have been about 2% higher than the 10-year Treasury yield. But in the mid-2000s, REIT yields actually dipped below Treasury yields. And this was pretty standard for most of the 1970s and 1980s.

Given that, unlike bond coupons, REIT dividends are presumed to grow over time, I believe a a relatively tight spread is completely appropriate. At a yield spread of 3%-4%, I would consider REITs a “fat pitch” investment worthy of a home run swing. But even today’s smaller spreads of 1.5%-2% are attractive if you believe, as I do, that Treasury yields will stay below 3% for the next several years and stock market returns will be middling at best.

Many of my favorite REITs, including Realty Income (O), LTC Properties (LTC) and Ventas (VTR), are yielding near or above 5% at current prices. But even the Vanguard REIT ETF (VNQ) is yielding close to 4%. I consider all of these to be strong buys on any Fed-induced sell-offs.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog. As of this writing, he was long VNQ, O, LTC, VTR.

Photo credit Kuba Zawadski

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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Accounting Irregularities Knock Down ARCP: Buying Opportunity or Enron Part 2?

It’s never a good sign when a company’s CFO and top accountant abruptly resign at the same time “accounting irregularities” are announced, but that’s exactly what happened at American Realty Capital Properties (ARCP) this morning.

An audit committee said, in a nutshell, that every quarterly report put out this year should be discarded and that the number from last year’s annual report shouldn’t be relied upon.

This is the sort of thing that makes investors dump a stock first and ask questions later.  At time of writing, ARCP was down about 30% on the day  after being down significantly more.

Given the extent of Wednesday’s stock implosion, I would consider this a buying opportunity in ARCP—albeit a risky one.  In the interests of full disclosure, I added to my existing position in ARCP at prices ranging from $8.22 to $8.48, and we’re a little above those levels now.  But I believe that ARCP could easily deliver total returns including dividends of 50% or more in the next six months if the accounting irregularities end up being anything short of catastrophic.

Let’s take a look at the numbers.  Based on the preliminary reports, the 2014 Q1 adjusted funds from operations (“AFFO”) of $0.26 would be cut to $0.23, and the Q2 AFFO of $0.24 would be cut to $0.22. The audit committee believes that the 2013 numbers are probably accurate, though they are still investigating.

The worst aspect is that there are allegations that management—or at least the CFO—knew about the irregularities and knowingly abetted them.

Still, let’s keep this in perspective.  We’re talking about a difference of 5 cents over two calendar quarters.  Still, this doesn’t cover the 8.3-cent monthly dividend—which could mean that a dividend cut is a real possibility.

I’m not too worried about a dividend cut in the immediate future, though anything is possible.  ARCP should have plenty of access to cash to sustain that dividend, though it probably won’t be growing it much.  Furthermore, even before today’s meltdown, ARCP was modestly cheap.  Shares traded at book value, meaning the market was valuing ARCP’s management expertise at zero.  After today’s move, ARCP trades for about 75 cents on the dollar.  Stripping out goodwill and intangible assets,  ARCP still trades at slightly below tangible book value. Sure, some of ARCP’s properties–such as the Red Lobster purchase–might be hard to liquidate.  But buying a REIT for less than the value of its property gives us a decent margin of safety.

The biggest reason I am inclined to give ARCP the benefit of the doubt, however, is that company insiders have been steadily accumulating the shares throughout 2014. Ten different insiders—including the company’s general counsel—have purchased a combined $3 million since January of this year.

InsiderPositionDateBuy/SellSharesTrade PriceCost
Stanley William GDirector7/11/2014Buy10,000$12.66$126,600
Stanley William GDirector6/25/2014Buy18,000$12.39$223,000
Silfen Richard AEVP and General Council6/25/2014Buy4,850$12.34$59,800
Silfen Richard AEVP and General Council6/11/2014Buy7,500$11.80$88,500
Stanley William GDirector5/23/2014Buy24,000$12.35$296,400
Bowman Scott J.Director5/21/2014Buy10,000$12.27$122,700
Bowman Scott J.Director5/16/2014Buy10,000$13.08$130,800
Weil Edward M Jr.Director4/21/2014Buy7,500$13.28$99,600
Beeson LisaCOO3/28/2014Buy3,500$13.88$48,600
Weil Edward M Jr.Director3/28/2014Buy10,000$13.80$138,000
Schorsch Nicholas SChairman of the BoD and CEO3/27/2014Buy50,000$13.78$689,000
Block Brian SEVP, Treas, Secy and CFO3/27/2014Buy20,000$13.8$276,000
Kahane William MDirector3/27/2014Buy25,000$13.78$344,500
Kay David SPresident3/27/2014Buy15,000$13.78$206,700
Michelson Leslie DDirector1/28/2014Buy700$13.94$9,800
Michelson Leslie DDirector1/17/2014Buy6,900$13.53$93,400

Is it possible that they’ve all been bamboozled by a crooked CFO who had been cooking the books?  Sure.  Stranger things have happened, and it’s a legitimate risk.  But it’s a risk I consider worth taking for now given ARCP’s pricing after the rout.

The most likely scenario here is that, due to incompetence and not mal intent, ARCP’s now departed CFO and Chief Accounting Officer botched their reporting by a few cents.  That’s bad—really bad.  But not quite bad enough to justify lopping off a third of the company’s market cap.

My advice: Use this selloff as an opportunity. I should reiterate that this is a risky investment.  The auditors could come back and find that the accounting irregularities go deeper than originally reported, in which case ARCP would potentially see a lot more downside.  But given the extent of the selloff and the steady insider buying, it’s a risk I’m comfortable taking.  And of course, the usual caveats apply here: be smart, use sensible position sizing, and have an exit plan.

Disclosures: Long ARCP

Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays. 

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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