The coronavirus has accelerated an enormous and previously slow-moving secular change in the commercial real estate industry. REIT investing isn’t what it used to be. Specifically, online shopping (retail), telecommuting (office), logistics (industrial), public safety (healthcare), the internet (data center) and zero-rate interest (mortgage) have dramatically shifted the relative attractiveness of various REIT business models and sub-industries. You can try to time the day-to-date REIT market volatility as if you were a professional trader (you’ll likely get smoked), or you can admit the vast new paradigm, and take the long view. This article explains our view on the evolved REIT reality and highlights three attractive “Strong Buy” REITs in the process.
Current Market Overview:
Before getting into the examples of specific REIT industries and opportunities, it’s worth considering the current market environment. Specifically, there are three big drivers of the current market nosedive (coronavirus, low oil prices and market valuation sentiment), and interest rates are extremely important to consider as well.
The Coronavirus
The market’s reaction to the coronavirus is more than just fear. There are very real impacts to the economy that will impact all stocks in varying ways. For example, most major sporting events (e.g. the NBA, March Madness) have been cancelled. That’s a lot of tickets sales, concession sales and advertising dollars that have now vanished into thin air. Similarly, hordes of people are cancelling airline tickets and non-essential travel. With regards to REITs, there are specific cases of coronavirus outbreaks at senior living properties owned by popular REITs. Also, foot traffic at shopping malls (and shopping mall REITs) will be dramatically impacted as more people practice social distancing. Those are just a few examples, and the full list is extraordinarily wide-ranging. The impacts of the cornavirus to the economy are no joke
Energy Prices
You may think the plummeting price of oil has nothing to do with REITs. But it does. First of all, it has most certainly contributed to the market fear and selling that has impacted all stocks (including REITs). Further, it impacts certain geographical regions more than others (for example, the sub-economy of the Houston-area can be more impacted by the energy price slump because of the significant exposure to the energy sector in that region). Further, low energy prices are contributing to the overall weakness in the economy in a dramatic way.
Market Valuation
The market hadn’t gone straight up for 10 years following the financial crisis, but it was fairly close, and valuations were getting very frothy by multiple valuation metrics. We’re not going to spend too much time on this one because frothy valuations can get frothier, and cheap valuations can get cheaper. Nonetheless, it almost seemed as if the market was just looking for an excuse to blow off some steam, and it certainly found it in the coronavirus and plummeting energy prices. However, we will say that disciplined long-term investing has proven to be a winning strategy over and over again throughout history, and there are a lot of attractive REIT opportunities out there right now.
Interest Rates
Interest Rates are a huge factor for REITs. And in relatively short order, the market has gone from expecting rising rates, to the opposite. Rates were recently cut in dramatic fashion to near 0%.
REITs rely heavily on the capital markets to fund growth, and lower rates makes funding that growth cheaper. Further, as investors are starved for yield (US treasuries certainly don’t yield what they used to), REITs can become relatively much more attractive for income-focused investors.
When Will the Selling End?
The stock market has been absolutely brutal in recent weeks, and high dividend investments have been even worse. There will be very real, very big, impacts to the economy. And there will most certainly be dividend cuts. But when and how does this all end? If China’s coronavirus lifecycle is any indication (recall the outbreak occurred there a couple months before the rest of the world), the spread will eventually slow, and people will get better. Further, and encouragingly, there is testing underway for a coronavirus vaccine. Importantly, the pandemic will eventually end, and the market will recover.
The REIT Landscape has changed
With that overview in mind, here are the specifics on the changes to the REIT landscape, broken down by industry (i.e. retail, office, industrial data center, healthcare and mortgage).
Retail REITs
In case you’ve been living under a rock for the last 10 years, the way people purchase things has changed dramatically. Of course, we’re talking about online shopping, but we’re also talking about electronic payments. Ten years ago, most people wouldn’t think of shopping online. However, Amazon (AMZN) has changed that, but so too have most successful retail stores also created a strong online presence. Further, companies like Shopify (SHOP) have made it simpler for small business to create formidable online presences. Further still, electronic payment companies like Square (SQ), Stripe (privately held) and PagSeguro (PAGS) have made cash increasingly unnecessary. Retail has changed.
With regards to retail REITs, that too has changed dramatically. Plenty of investors, for years, have proclaimed that it’s just the B-Class retail REITs that will die (e.g. (WPG) (CBL)), and the A-Class malls will be fine. But with the dramatic decline in share prices for A-Class malls with fortress balance sheets (such as Simon Property Group (SPG)) the market seems to clearly believe they will not be spared by the relentless evolution of online shopping.
Simon Property Group (SPG)
In our view, Simon will most certainly continue to be negatively impacted by online shopping as more of its retail store tenants file for bankruptcy. And the coronavirus outbreak will most certainly accelerate these bankruptcies as the concept of “social distancing” grows (shoppers stay away from the malls, and more brick-and-mortar retailers throw in the towel). The primary question is whether Simon itself will eventually file for bankruptcy, or if it can co-exist with online shopping. The secondary question is whether the price has already fallen too far (or not far enough) among the current retail apocalypse, as well as the coronavirus (which many believe will inevitably drag the US into recession). For a little more perspective, here is a look at the dramatic sell off in Simon shares as compared to the average Wall Street analyst price target.
source: FactSet
We’ll have more to say about Simon in the conclusion of this report.
Industrial REITs
As retail stores continue file for bankruptcy, there are specific industrial REITs that actually benefit significantly from the grow of online shopping. In particular, there are a variety of industrial REITs with properties strategically located along the online shopping supply chain. They have prime location properties that products purchased online passthrough before finally being delivered to the stay-at-home customer. For the industrial REITs in this position, it can be a very good position to be in.
EastGroup Properties (EGP)
EastGroup Properties is an example of a REIT that actually benefits from the growth in online shopping, in part because of its “last mile e-commerce locations.” If you don’t know, EastGroup is a self-administered equity REIT focused on industrial properties in major Sunbelt markets (mainly in Florida, Texas, Arizona, California and North Carolina). The Company's strategy for growth is based on ownership of premier distribution facilities generally clustered near major transportation features in supply-constrained submarkets. For a little perspective, EastGroup counts online retailers, such as Amazon and Wayfair, as customers. We like EGP’s strategy, and we also like that its funds from operations (“FFO”) payout ratio was only 59% in 2019 (this gives the business and the dividend a lot of extra cushion, considering current market conditions).
We currently own shares of EGP (we purchased in 2016), and without question we understand that the current coronavirus turmoil will impact the business. However, given its strategy and strategic property locations, we look forward to its healthy price increases in the months and years ahead as it weathers the current market wide storm better than others.
Data Center REITs
As the digital world grows, so too has the need for data center REITs. A data center is a physical facility that organizations use to house their servers, critical applications and data. Data center REITs own and manage these facilities. The need for secure and reliable data storage has exploded in recent years and is expected to continue to remain strong. This is fueling demand for data center REITs.
Digital Realty Trust (DLR)
One example of data center REIT that we currently own is Digital Realty. DLR’s shares have actually performed well this year, despite the broader market turmoil, and we expect them to continue performing well in the years ahead. More specifically, we believe the coronavirus outbreak helps highlight the attractiveness of data center REITs, considering they are mission critical and not a lot of people are even allowed to gather at data center REIT sites (which incidentally is good for social distancing, especially as compared to other types of REITs). You can access our last full report on Digital Realty here.
Mortgage REITs
Mortgage REITs invest in financial assets related to mortgages. And they have gotten absolutely slaughtered amongst the recent market turmoil considering they generally use high amounts of leverage, and are averse to violent changes in interest (as we’ve experienced recently). When market conditions are conducive these big-dividend payers can be an income-investor favorite. But when conditions get rough things can get bad quickly
New Residential (NRZ)
New Residential is one example of a mortgage REIT that has been hurt very badly during the recent market turmoil. We warned investors just a couple short months ago that this was going to happen when market conditions got ugly (see New Residential: Levered Cluster Bomb), we just didn’t expect market conditions to get as ugly as they have so quickly. The issue for NRZ is their massive amount of mortgage servicing rights (MSRs) which get recked when mortgage prepayment speeds accelerate (like they just did thanks to the Fed’s emergency rate cuts). The company’s MSRs are now worth dramatically less than NRZ paid for them (especially considering the levered balance sheet NRZ used to pay for them), and there is really no easy way for NRZ to get out of this mess. The company is attempting to stop the bleeding by accelerating its mortgage underwriting business, but given the extreme competition in that space, investors have been unimpressed, and the shares have gotten absolutely destroyed.
Healthcare REITs
Healthcare REITs, particularly senior living and nursing home properties have been dealing with oversupply issues in recent years as they built for a massive demographic “aging population” wave that has been slow to pay off, especially in light of pressure on medical reimbursement rates. And now with the coronavirus, these types of facilities seem even less attractive. For example, multiple popular healthcare REIT facilities have recently been plagued with coronavirus outbreaks, and their share prices have performed dramatically worse than our horrible stock market.
The GEO Group (GEO)
One healthcare REIT that faces significant challenges of its own is The GEO Group. Generally speaking, GEO owns private prisons, it faces a seesaw of intense political backlash, and it has also been lumped in with out healthcare REITs thereby magnifying the selling pressure. Nonetheless, we still believe this is a healthy mission-critical business, and it’s a strong buy. You can access our full report on The GEO Group here.
Office REITs:
The recent coronavirus outbreak is highlighting just how prepared, and unprepared, some businesses are. For example, as employees are encouraged to work from home (per social distancing initiatives), some companies can accommodate this change and some cannot. And as people try to stay safe, many would love to work from home instead of bearing crowded trains and planes just to get to crowded office spaces. Further still, this may accelerate the trend towards telecommuting and put pressure on office property REITs.
Brookfield Property REIT (BPYU)
Brookfield Property is a commercial REIT with significant exposure (41% of its assets) to office properties (the remainder is mainly retail, and then some private real estate fund investments). As a result, the shares of Brookfield have taken an extreme beating. Specifically, the company’s already highly levered balance sheet faces a new wave of extraordinary challenges as the coronavirus impacts the demand for office space.
One thing that is encouraging about Brookfield (besides its extremely low price) is that it was spun off by Brookfield Asset Management (BAM) in 2013, and BAM remains the major shareholder with ~53% interest. We view this as a significant advantage considering its pedigree of distressed investing and its history of creating shareholder wealth. One general investing notion says higher risk investments can offer higher rewards. Brookfield is on the higher risk end of the spectrum. You can read our full Brookfield report here.
Conclusion
The market is taking a beating like never before. And many high-income investments are taking the worst of it. Some business will file for bankruptcy and others will rebound dramatically in the months and years ahead. Rather than panicking over the near-term volatility, investors may want to take note of the opportunities, particularly the changing REIT landscape.
In particular, the three “Strong Buys” in this report are Simon Property Group (simply because we believe the market has overreacted to the risks on an extraordinarily extreme level), The GEO Group (because it is a mission critical business with mission critical assets), and EastGroup Properties (because even in a social distancing and online shopping world, EGP does well). Regarding Digital Realty, it’s an attractive business (and we own it) but we can only rate it a “Buy” (not a “Strong Buy”) because the shares have already done so well this year (i.e. valuation). Regarding Brookfield, it’s worth considering if you have a high tolerance for risk (sometimes the riskiest investments offer the highest rewards). Finally, with regards to New Residential, even though its share price is down so extremely far, the company’s talented CEO Michael Nierenberg is going to need to pull a rabbit out of his hat on that business model (this is why investors should always stay prudently diversified—in case something blows up!).
If you are looking for more REIT opportunities, specifically higher dividend REITs, you might want to consider our recent report: Top 10 Big-Dividend REITs. However, and importantly, don’t lose sight of your long-term investment goals during this period of extraordinary market turmoil. Things will get better, and disciplined long-term investing has proven to be a winning strategy over and over again throughout history.