My Oh My, 3 Strong Buys

REITs outclassed the S&P 500 by ~15pp in 2021 (after five years of consecutive underperformance) and REIT fundamentals continue improving (+9% FFO per share in 2021).

We expect even better growth in 2022 (estimate 12% FFO growth) with accelerated double-digit growth in apartments, healthcare, industrial, office, and cannabis.

Notably Prologis (PLD) hit the ball out of the park in Q4-21, after reporting FFO per share of $1.12 per share, +17.9% year-over-year. Also in Q4 PLD saw rents rise 510 bps, with same store NOI rising by 7.5%.

PLD provided full-year 2022 guidance, which calls for high single digit Core FFO growth (7.7% at the midpoint) and continued same-store-rent growth.

Another REIT with strong solid earnings news is Camden Property Trust (CPT) that saw NOI rise by 14.9% year over year. The sunbelt apartment REIT said 2022 should be the best year on record for earnings as it guided FFO per share of $6.24 and NOI growth of 12% (at the midpoint).

Boston Properties (BXP) posted Q4 earnings of $1.55 per share, + 13.1% year over year and reiterated 2022 FFO per share guidance of $7.30 to $7.45, 12.4% y/y growth at the midpoint.

In a research report, Cohen & Steers said that “cash flow growth for global REITs is expected to remain well above historical averages. Growth in funds from operations is forecast to reach 15.7% this year, up from 13.3% in 2021 and well above the long-term average of 5.9%.”

How is it possible that REITs generate better earnings in 2021, amid elevated inflation?

Cohen & Steers explains that “elevated inflation provides a solid backdrop for REITs” and “we believe that, after a decade of downward surprises, inflation levels are likely to remain higher than over the last economic cycle — even if central banks raise interest rates and supply-chain bottlenecks abate.”

Cohen & Steers adds that,

“Central banks such as the U.S. Federal Reserve have indicated they may begin to raise interest rates to combat rising prices. For REIT investors, rising rates should not typically be cause for concern. Between 2004 and mid-2006, for example, the Fed hiked interest rates 17 times (from 1.0% to 5.25%) amid an improving economy, and yet REITs outperformed stocks and bonds during this period.”

While long-term interest rates can affect capital costs, an expanding economy typically drives stronger demand, often leading to higher occupancy levels, which can give landlords the ability to offset rates.

While income levels from traditional asset classes remain at historically low levels, REITs have continued to offer attractive dividend yields that range from an average of 4.1% in North America and 4.8% in Europe. As Cohen & Steers points out,

“In all regions, REIT dividend yields are well above the respective 10-year government bond yields. In addition, given the strong fundamental backdrop for REITs, we believe the asset class could see dividend growth in 2022.”

Screening for Value

In addition to the potential benefits of growth, inflation sensitivity and income, REITs are attractively valued, broadly speaking.

One of the great things about investing in REITs is that investors can gain access to a variety of property categories, and of course, each offer a unique risk profile.

As you can see below, the sector trades at 22.0x and all of the sectors have underperformed year-to-date. The most beaten down categories include malls (-17% YTD), cannabis (-15.5% YTD), cell towers (-14.2% YTD), and data centers (-10.3% YTD).

In late December, we sold many positions in the Cash Is King portfolio, recognizing that valuations were getting frothy. Keep in mind that this higher risk portfolio has high churn, and that’s the opposite of our more conservative Durable Income Portfolio (that’s more buy-and-hold).

Our objective with the Cash Is King portfolio is to capitalize on COVID mispricing opportunities as we commenced the strategy in March 2020. Several of our top performing positions in the portfolio:

• Hannon Armstrong (HASI) +193%
• Essential Properties (EPRT) +144%
• Ladder Capital (LADR) +107%
• Ventas Inc. (VTR) +98%
• Iron Mountain (IRM) +91%

With REIT shares pulling back in January, we’re laser-focused on recycling capital in the Cash is King portfolio. We consider above-average earnings/dividend growth, positive historical performance in periods of rising rates, and attractive valuations solid reasons to put the cash to work.

Utilizing our tools at iREIT on Alpha, we have screened for the property sectors that offer the best risk-adjusted returns. As you can see below, we assign a quality and valuation rating to each REIT in our coverage spectrum, and you can see (below) the sectors that consider the most favorable.

We’re screening for value and quality scores that are 60 or higher and of course the ideal REIT will have both high quality (like PLD that scores 100 in quality) and wide margin of safety.

However, many property sectors remain expensive (such as Industrial and Apartments), so we’ll focus on these seven sectors that offer the best bang for the buck.

Furthermore, we’ll be looking for REITs within these sectors that have strong fundamentals and that are able to drive potential multiple contraction.

Our Cash is King portfolio has generated spectacular returns since commencement, and we will be looking to repeat that performance with a target annual return of over 40%.

As illustrated below, we screened to generate the list of a dozen of our best buys, ranked by their margin of safety. As you can see in the far-right column, all of these REITs – except for CorEnergy (CORR) – have seen red numbers so far in 2022.

Now let’s take a look at 3 of the most beaten down names:

• Safehold (SAFE) -24.2% YTD
• Innovative Industrial (IIPR) -22.6%
• Hannon Armstrong (HASI) -24.3% YTD

One of the “Safest” REITs Goes on Sale

Safehold (SAFE) is a unique net lease REIT that focuses exclusively on ground leases, that is, the land underlying the types of buildings most other REITs invest in. As I explained in a deep-dive article,

“…the ground lease investments offer a fundamentally lower risk profile and can create a unique mix of desirable investment attributes, including principal safety (ground leases are considered to be one of the safest positions in real estate), increasing income (ground leases generate inflation-protected income streams that consistently compound over long periods of time) and future growth (by focusing on a market with few competitors that has the potential for significant growth).”

As many of my followers know, I’m not a big fan of externally managed REITs, but SAFE is one a handful of exceptions.

The company is managed by iSTAR (STAR) and last week this company announced it was selling a portfolio of net lease assets, consisting of 18.3M square feet of office, entertainment, and industrial properties, for $3.07B to Carlyle Group’s (CG) Global Credit platform.

I caught up with the CEO (of STAR & SAFE), Jay Sugarman, to discuss the latest news and he said,

“…we’ll net about $250 million above gross book value, which I don’t think any analyst were giving us credit for. As much as we like the net lease business, it’s been part of our company for over two decades. But we realize the ground lease business is really where our future lies. And iStar has been nurturing that business both with Safehold and in some separate areas. So this was another step in the direction we laid out a couple years ago.”

What Sugarman was suggesting is the likely possibility of internalizing SAFE, because STAR’s is deemed a complex business model. Clearly, Sugarman and his team are focused on the ground lease business that is viewed “as the next evolutionary wave in commercial real estate.”

SAFE is an equity REIT differentiated by the fact that the ground lease is senior in structure to traditional equity REITs. So, when you think about the business in terms of a property’s capital stack of $100 million, that includes land + building, the ground lease is sized somewhere between $35 million and $40 million.

The ground lease is the most senior claim and if you don’t pay the ground rent, you lose the whole $100 million investment, and it goes back to the landowner. There are hardly ever defaults because nobody is going to give up the building.

This means that these ground leases are effectively AAA, analogous to the senior-most position in a commercial mortgage-backed security (“CMBS”) deal where 0% to 35% is AAA, 35% to 50% is A or AA, 50% to 75% is B to BBB and then everything below 75% is the risky sub investment grade.

Some analysts have compared SAFE to traditional equity REITs, but this is disingenuous because these REITs have a higher degree of default risk because they are closer to BBB in terms of their default profile.

While many REITs were forced to cut dividends through COVID in 2020, SAFE collected 100% of its ground rents, because ground leases are in effect a super senior super safe position.

SAFE has underperformed the REIT sector YTD (-23.9%) mainly due to macro headwinds for its longer-term ground leases and partly because of perceived slower growth (as investment spreads narrow in the face of cap rate compression). I asked Sugarman about the growth platform and he said,

“We have put out the guidance that we would double the size of the portfolio from 2021 to 2023. And over that three-year period, we would grow from about $3.2 billion of assets to $6.4 billion of assets. So that’s the marker out in the world. And we said we’d be disappointed if we couldn’t beat that.”

This unique business model (at least in the REIT sector) is highly fragmented, and as Sugarman points out,

“We wanted to be in the top 30 cities in the United States. We’re getting very, very close to covering that map. We want our customers to do more than one deal with us. So, repeat customer business is really important. We’ve seen those numbers as high as 50% and as high as 65% in terms of a new transactions we’re looking at, typically our best calling card is someone that does a deal with us, or even just goes through the process with us, we get a lot of converts and a lot of people who really come to realize that this is a better capitalization tool for them to use.”

As a developer myself (for over two decades) I get the ground lease model, as I have constructed buildings for Rite Aid, PetSmart, Red Lobster, and others on a ground lease. Sugarman adds,

“… we think (ground leases) are a $7 trillion addressable market, so plenty of room to grow.”

Although SAFE has dropped by around 23% so far in 2022, analysts are forecasting growth of 31% in 2022. The dividend is well-covered, and STAR continues to buy shares in SAFE on a very frequent basis.

In terms of valuation, you can see below that shares are trading at 43.8x P/E, compared with the normal multiple of 48.9x. Also, you can see that in 2021 SAFE traded as high as 72x. The dividend yield is certainly modest, just 1.12%, but we do see value in the unrealized capital gains (I’m writing a separate article on that topic this week).

Also, there’s no reason for us to consider FFO here, because SAFE owns no improvements, thus ordinary GAAP earnings are the metric of choice. Thus, there’s no reason to compare SAFE to a traditional equity REIT because the risk-reward thesis is much different.

As viewed below, we view SAFE as a Safe Strong Buy. The company could generate returns of at least 30% over the next twelve months. Sugarman and his team continue to execute according to plan and we are capitalizing on the mispricing opportunities.

Anybody Like this Highflyer?

We began covering Innovative Industrial (IIPR) back in 2018 and here’s what we said at then,

“Founded in 2016, IIPR was the first REIT to specialize in serving the fast-growing US medical cannabis industry. The company operates under the sale-leaseback model, meaning it acquires an industrial property and then leases its use back to state-licensed medical-use cannabis growers. The tenant is responsible for maintenance, property taxes, and insurance, and IIPR merely collects extremely high margin rent.”

I’ll get to these outrageous investment spreads later but let me point out the inflation protecting IIP has built into its platform. As the CEO, Paul Smithers, told me in a recent Ground Up podcast,

“We have a built-in average 3% escalator. And we have a weighted average lease length of about 16 and a half years. So, we have that built in escalator for the length of the leases. So, we love that.

As far as conversations with the operators, and inflation, I think if you’re a successful operator, you still have excellent margins. So, they’re still being able to really do well. Maybe their operating expenses go up, maybe payroll goes up, but yes, in those states, most of the states we’re in, it’s a strong cannabis price. We haven’t seen a lot of fluctuation in most states. It’s been a good year.”

When IIPR started out (5 years ago) its only option for capital was equity, and using its common shares to grow. During these years, there was really no debt available in the industry. However, in May 2021 IIPR had its first bond offering, and even now, the company is modestly leveraged at around 20%.

What’s really unique to IIPR – and the other cannabis REITs – is the outsized investment spreads that are generated. Last week IIPR launched a public offering of $300M of senior notes due 2027 and in January the company updated its Q4 operating investments: it made 29 acquisitions of properties in five states and executed one lease amendment with a total investment (during Q4) of ~$176.1M.

As viewed below, analysts are forecasting AFFO per share growth of 32% in 2022 (and 26% in 2023). The playing field is definitely becoming more competitive – we recently added NewLake Capital (OTCQX:NLCP) and AFC Gamma (AFCG) to our coverage spectrum – however, we see value in IIPR’s first mover advantage (and NYSE listing).

As you can see (above), IIPR is trading at 28.1x P/AFFO, around 23% below the normal P/AFFO (of 33.3x) and around 35% below the November 2021 multiple of 43.4x. Also, IIPR’s dividend yield is 3.1% (and well-covered) and we are forecasting the company to return ~50% over the next 12 months. Again, we consider the latest selloff irrational, and we are maintaining a strong buy recommendation.

Not Lance Armstrong, But Hannon Armstrong

I had to include Lance in the title, and my little joke has to do with the fact that Hannon Armstrong (HASI) is one of the most sustainable REITs in our coverage spectrum. Some of you may recall my first article, back in February 2015, that caused HASI to gain some shelf space (so to speak). Here’s an excerpt from that article,

“HASI is clearly not a utility stock, but I believe the financier of clean energy is a sound sector with similarly reliable attributes. The predictability of HASI’s business model is driven by the high-quality contracts that support very stable income growth. I am recommending shares at the current price level and I believe a big part of the discounted valuation is reflected in the modest coverage (investor) base.”

As you can see (above), shares took off when I published my article (in 2015) and they kept climbing and climbing, up until COVID-19. Of course, we sold most of our shares in late 2020, based simply on valuation.

As a value investor, it’s important to hold stocks until they work, and sell them when they have reached full valuation.

We provide trim targets for our members, and we have found this to be extremely useful. Our objective is to alert our members when the price reaches its fair value and we do not provide a specific timeframe because we have no idea what Mr. Market is thinking…

As you can see, had you bought shares on day one (when we recommended buying) up until January 2021 (when we sold), you would have generated annual returns of just under 34% per year.

It’s okay if you missed the opportunity, because, in the words of Mark Twain, “History doesn’t repeat itself, but it does rhyme”. (By the way, I’ve found no compelling evidence that he ever said it). As I pointed out in a recent article,

“Compared to all other mREITs we follow, HASI is No. 1 for cumulative credit losses – above 0.20% since 2012 – and percentage of performing loans. As of the end of Q3, 99% of loans were performing. And the remainder fell into the “slightly below metrics” category.

And HASI performed pretty consistently during 2020’s panic. In part, that’s because people never stopped using electricity. But it’s also due to HASI’s disciplined structuring deals with the right third parties.

A public utility isn’t going to stop paying HASI. A hotel, however, might skip a few payments if it doesn’t have the cash flow necessary from guests. That’s the difference at its core.”

I also pointed out that,

“Moving on to 2023-2025, we’re calculating per-share cash flow growth of 8%-12% each year. And our conservative estimate for 2024’s dividend is $1.60 per share, or about 14% growth from today. Very few mREITs are increasing cash flow per share more than 3%-5% a year.

Even fewer have business models with sufficient growth capacity that we can reliably expect high single-digit or low double-digit annual growth for many years to come.”

HASI also has the lowest leverage among its peers and the least loan losses since 2012. Additionally, HASI’s past and anticipated cash flow growth are roughly three times the commercial mREIT average. To say nothing of its long-term growth potential.

HASI shares have declined by around 23% in 2022, while analysts are forecasting growth of 4% in 2022 and 7% in 2023. Granted, this is not the same growth forecasted for the first two REITs I referenced earlier; however, we consider the valuation metrics appealing – shares trade at 22.2x P/E with a dividend yield of 3.4%.

We think 20x forward cash flow estimates roughly today’s share price and below is a very strong value proposition. As Q4-21 and Q1-22 delivers the expected results and assurances, we consider a price target of $65 reasonable. That’s about a 75% total return, assuming one year’s worth of dividends.

In Closing

As many REITs have been reset so far in 2022, we are always screening the globe for mispriced opportunities. Although I have not coined the “My Oh My, Another Strong Buy” phrase, I use it frequently to message readers that there’s a wide margin of safety, a core tenet of value investing.

I’ll be writing an article later this week explaining my successes within the Durable Income Portfolio that has averaged over 21% annually since 2013. Like all of our portfolios at iREIT on Alpha, the primary objective is to utilize fundamental-based research to overcome any and all biases, to create a protection against the “unknown unknowns”.

According to Benjamin Graham,

“The function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. If the margin is a large one, then it is enough to assume that future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time.”

Graham also wrote,

What then will we aim to accomplish in this book? Our main objective will be to guide the reader against the areas of possible substantial error and to develop policies with which he will be comfortable… For indeed, the investor’s chief problem – and even his worst enemy – is likely to be himself… “The fault, dear investor, is not in our stars – and not in our stocks – but in ourselves…”

So then, I’ll conclude where I started,

“My Oh My, 3 Strong Buys”.