2 REITs Most Investors Should Own

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2 REITs Most Investors Should Own

seekingalpha09-12

There is a minority of REITs that check all the boxes.High yield, steady growth, lower risk, and upside potential.I discuss 2 such REITs that most investors should consider. chaofannREITs (VNQ) are ...

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REITs are up nearly 10% over the past month alone, and this recent rally appears to have caught everyone's attention. Data by YChartsI know this firsthand because my articles are now getting more views, more comments, and people are signing to my newsletter, and a common question that they all ask me is: \"What are the best REITs to buy today?\" It is a tough question to answer because it depends entirely on what you are looking for. Some REITs are best suited for income investors, others are better for growth investors, and some are very risky upside plays. But there is a small minority of REITs that check all of the boxes, and could make sense for most investors. They are undervalued blue-chip REITs that offer high yields, strong growth, and future upside potential. Here are two examples that we are buying: Alexandria Real Estate (ARE) Alexandria is as close to the \"perfect REIT\" as you can get. Let's review each one by one:  Assets Balance sheet Management Valuation Risks  Assets: Alexandria is the only REIT that specializes in life science properties. As such, it owns mainly labs that it leases to big pharma and biotech companies for their research and development, and being the leader in this space, it has custom-built a portfolio of the Class A properties in the best markets of the nation:   Alexandria Real EstateIt is a great sector for landlords for a number of reasons:  High and growing demand: there is consistently more and more money being pumped into the research and development of new groundbreaking drugs, resulting in rapidly growing demand for lab space.  Low secular risk: every property type faces some technological risk, but it is hard to foresee a world in which lab space wouldn't be needed. You cannot do this from home, and AI cannot replace the need to conduct experiments.  Recession-proof: this is not a cyclical sector. The world is aging rapidly and the demand for healthcare services and products continues whether we are in a recession or not.  High tenant dependency: your tenants are housing millions worth of equipment, and possibly billions worth of intellectual property inside your buildings. Moving all of it from one building to another is not impossible, but it isn't practical, leading to consistent high occupancy rates for high-quality properties in desirable locations.  Strong leases: Alexandria has long leases, tenants pay all property expenses, and they also include 3% annual rent escalations, which is about 2x faster than the rent escalations of net lease REITs like Realty Income (O). UrbanizeAs a result, Alexandria has consistently enjoyed steady rent growth and high occupancy over the long run, and with the strong tailwinds of its sector, we think that this strong performance likely to continue. Balance sheet: Alexandria has one of the strongest balance sheets in the entire REIT sector with a BBB+ credit rating, a low 30% LTV, 13-year average debt maturity, and over $5 billion in liquidity. Therefore, the REIT is well protected from the risk of rising interest expense, and it is also well-positioned to invest in its future growth. Alexandria Real Estate Management: Alexandria's management has one of the best track records in the entire REIT sector, having managed to outperform even Warren Buffett's Berkshire Hathaway (BRK.B) over the long run: Data by YChartsREITs are typically perceived to be boring income investments, but Alexandria has managed to grow at a rapid pace, resulting in high total returns. Alexandria's management has consistently managed to supplement its organic rent growth with new development projects and acquisitions at large spreads over its cost of capital, resulting in significant shareholder value creation. Valuation: Alexandria has all the characteristics of a blue-chip REIT and therefore, it has during most times also traded at a blue-chip valuation. Its FFO multiple has commonly been between 20-30x, with its 5-year average being 25x. Note that this is the average, not the peak. But today, it is offered at just 12x FFO following the crash of its share price over the past two years: Data by YChartsBut despite the crash in its share price, the company is actually doing well and has kept even growing its cash flow and dividend: Alexandria Real Estate So why is it so cheap then? We think that there are three reasons, two of which do not make much sense: Firstly, all REITs are cheap today due to the surge in interest rates. It caused all REITs to crash because investors sold their REITs to reinvest in fixed income investments. Alexandria's fundamentals are not heavily impacted, but its share price has dropped regardless. The good news is that interest rates will now return to lower levels, and this could lead to a recovery in its share price. Secondly, the REIT often gets grouped with office REITs, despite not actually being one. We think that this has unfairly hurt its market sentiment in recent years. The third reason is a valid one, and it is oversupply. We discuss this further below: Risks: Right now, the main risk that's affecting Alexandria and causing its market sentiment to suffer is that the life science sector is oversupplied. Following the pandemic, a ton of money was being pumped into research, and this led to a boom in new construction activity for life science space. This supply is now hitting the market, and it is putting it in a state of oversupply. The market only cases about short-term results, so this is perceived as a significant headwind. But the oversupply should be just temporary. Real estate markets are cyclical, and times of oversupply are commonly followed by times of undersupply. Today, there is very little new space being built because the surge in interest rates and construction cost put most new development projects on halt. 2024 and 2025 will be harder years, but if you can look beyond that, the future looks bright. Moreover, Alexandria is well protected even in this oversupplied environment because it enjoys long leases with steady rent hikes, and its lease rates are below market, providing further margin of safety. The REIT also has little leverage and plenty of liquidity to take advantage of opportunities that may present themselves. Takeaway: Alexandria is a blue-chip REIT with great long-term prospects that's today priced at a historically low valuation due to temporary concerns. Interest rates will soon return to lower levels, and the oversupply won't last forever. Within just a year from now, the environment could be a lot better already, and this could lead to significant upside for investors who buy Alexandria today. Simply returning to 18x FFO would result in 50% upside, and it would still trade at a historically low valuation multiple. While you wait, you earn a 4.5% dividend yield and the company has guided to grow its cash flow by 5% this year, even despite the oversupply. We love the risk-to-reward and will accumulate more at any dip. W. P. Carey (WPC) W. P. Carey is a similar story in that it is also what we would describe as a \"blue-chip REIT\" and yet, it is currently priced at a discounted valuation. Let's do the same thing and review each of these one by one:  Assets Balance sheet Management Valuation Risks  Assets: W. P. Carey is a net lease REIT, just like Realty Income. The main differences are that W. P. Carey invests mostly in industrial net lease properties, whereas Realty Income focuses mainly on retail. Moreover, W. P. Carey also enjoys superior lease escalators, typically tied to inflation, which are resulting in much faster rent growth:     W. P. Carey Realty Income   Focus Industrial Retail   Rent growth ~3% ~1.5%   Click to enlarge Costar Today, most industrial REITs are priced at relatively high valuations because of the growing trends of onshoring and e-commerce. It is leading to rapidly growing demand for industrial space and puts WPC in a strong position to grow its rents over the long run. Balance sheet: Its balance sheet is not quite as good as that of Alexandria, but it is strong, nonetheless, with an investment grade rating and a relatively low 39% LTV. Unique to WPC is that it is also very active in Europe where interest rates are materially lower, giving it access to cheaper capital to acquire additional properties. W. P. Carey Management: A lot of investors dislike WPC's management because of one thing. They recently decided to spin off their office properties into a separate REIT to get rid of their worst assets. This naturally lowered their cash flow, so they cut the dividend. Income investors felt betrayed by the management. But if you think rationally in terms of the REIT's future long-term prospects, this decision makes a lot of sense. Selling the office properties had become near impossible, and holding on to them would lead to significant issues down the line, hurting their market sentiment for many years to come. But getting rid of the assets allowed them to rip off the band-aid, restart with a stronger portfolio than ever, lower leverage, and lots of retained cash flow to reinvest in growth. The management knows what it is doing. Here is WPC's long-term track record: Data by YChartsYou don't achieve a multi-decade track record of significant outperformance by accident. WPC is very well managed, and while its recent spin-off wasn't a popular decision, it will likely benefit shareholders over the long run. Valuation: Despite being stronger than ever, WPC is today still priced at one of the lowest valuations in its history, largely due to the unpopular decision of cutting the dividend. Its shares are down ~30% from their peak, and they now trade at just 12x FFO, a historically low multiple for such a high quality net lease REIT. Its industrial net lease peers trade at materially higher levels today:     W. P. Carey Industrial Net Lease REITs   FFO Multiple 12x 17x   Click to enlarge We think that this is an opportunity. The disgruntled income investors will eventually be replaced by growth oriented investors and the company's market sentiment will recover, especially as it returns to growing its cash flow and dividend in the coming years. As a reminder, Agree Realty (ADC) cut its dividend in 2011, and it was then the most rewarding net lease REIT in the next decade as it rebuilt from a low valuation. I believe that there are a lot of similarities to WPC's situation today. The REIT offers a near 6% dividend yield, it has the potential to grow by 4% per year over the long run, and I expect it to eventually reprice at closer to 16x FFO, which would unlock 30% upside from here. Combine all of this together, and you have the potential to earn 15-20% annual total returns in the coming years, which is very attractive coming from a relatively defensive REIT. Risks: What's the main risk? It is that interest rates remain higher for longer. WPC has a bit more leverage than its peers, and its debt maturities are also relatively short. This is nothing catastrophic as the REIT still has a good balance sheet, but it could cause its cash flow to stagnate if interest rates remain high, potentially delaying the recovery in its share price. We think that interest rates are very likely to be cut in the near term and therefore, we aren't too worried about this. Closing Note If I was a new REIT investor, I would invest in such REITs to build the foundation of my portfolio.  High quality, yet discounted due to temporary factors.","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"1","news_tag":"analysis","news_rank":0,"symbols":[],"gpt_button":0},"commentList":[],"hasMoreComments":false,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false}}