In short, I think that REITs provide the best risk-to-reward in today’s environment because of 8 reasons:
- (1) They are at least somewhat recession-resistant: REITs have enjoyed nearly 2x better downside protection during past recessions on average;
- (2) They offer superior inflation protection: Rents are growing rapidly and so are the value of their assets – all while their debt is inflated away;
- (3) They offer a hedge against rising interest rates: REITs today have the lowest debt in their history and very long debt maturities. Therefore, the negative impact of rate hikes will be much lower than the positive impact of inflation. This is why REITs tend to outperform during times of rising rates;
- (4) They are insulated from geopolitical risk: Today, there are growing tensions between the east and the west. Russia’s invasion of Ukraine and China’s zero-tolerance approach to covid-19 are pushing a lot of companies to leave some markets and rethink their supply chains. This leads to costs and lost profits. REITs are not directly impacted by these geopolitical risks;
- (5) They have attractive growth prospects: Most property sectors have been underbuilt over the past decade, and even more so in the recent past due to all the supply chain issues caused by the pandemic. And as a result, rents are rising fast and REITs have the opportunity to build new properties at high rates of return;
- (6) We earn dividend payments while we wait: There are many high-quality REITs that yield up to 6-7% in today’s market. By earning high income, we are less reliant on market appreciation in case we face a lost decade as some are predicting. We only need 3-4% annual growth to reach double-digit annual returns;
- (7) Valuations are steeply discounted: Today, REIT share prices are still barely getting back to where they were before the pandemic two years ago, but we all know that real estate has experienced significant appreciation since then. As a result, REITs are now trading at large discounts to the underlying value of their properties;
- (8) The end of the pandemic is a clear catalyst: The main reason why REITs are discounted is the pandemic. It caused their market sentiment to suffer due to the false perception that REITs own a lot of office buildings when in reality, just around 5% of REITs specialize in offices. As we slowly move past the pandemic, increasingly investors will return to REITs to diversify their portfolios and seek inflation and recession protection.
Here is how REITs have historically performed during times of high inflation:
And yet, most of them are today heavily discounted…
But before you rush to buy just any REIT, remember that not all of them are created equal. There are over 200 of them, and while we are bullish on the sector as a whole, we really only invest in 1 out of 10 on average at High Yield Landlord.
Some property sectors are challenged. Some management teams are conflicted. And some balance sheets are better prepared for rising rates than others. Being selective is key in this sector:
The market is crashing, here’s what I am buying:
Today, apartment REITs are highly desirable. They offer inflation protection, recession resistance, and rents are growing rapidly because we haven’t built enough apartments over the past decade and increasingly many people cannot afford to buy a home, especially following the recent surge in interest rates. Most major apartment REITs like Mid-America Apartment Communities, Inc. (MAA) and Independence Realty Trust (IRT) are attractive, but our top pick is BSR REIT, a small-cap that owns mainly communities in rapidly growing Texas cities like Austin and Dallas.
Over the past year, its portfolio rose in value by 66% as it was able to push for significant rent hikes. This year, we expect more of the same because the company still hasn’t renewed all of its leases and it is able to push for more rent hikes. In the first quarter, new leases were signed at 17.4% higher rents, which is twice the rate of inflation!
Despite that, the company is today priced at a 25% discount on the underlying value of its assets. By the end of the year, the discount will likely expand closer to 30-40% if the company’s share price doesn’t appreciate.
It is rare to be able to buy such desirable assets at a steep discount. Typically, the REIT market prices such companies at a large premium.
While we wait for the upside, we earn a 3% monthly dividend yield that’s well covered with a 63% payout ratio and set for more growth in the coming quarters.
Our largest German real estate investment is priced at the lowest level since late 2020, and that’s despite posting strong growth in 2021 and giving us strong guidance for 2022.
We think that the shares were undervalued at €16, and they recently dropped back down to €12.50. At the same time, the Euro has also lost value relative to the U.S. Dollar, making it even cheaper for American investors.
This drop is, of course caused by Russia’s invasion of Ukraine, which causes great uncertainty in Europe. A recession could be imminent, energy prices are going up, and inflation is only accelerating. It is undeniable that Russia’s invasion of Ukraine creates new risks that we didn’t account for.
However, the best opportunities emerge during times of crisis, and this is a good example of that. It could lead to disappointing results in the next 12 months, but it won’t impact the long-term trajectory of the company, and therefore, we think that the market is overreacting.
Something that the market appears to ignore is that German real estate is perceived to be “Europe’s safe-haven” asset class. Therefore, this crisis could potentially benefit DIC in the years ahead as increasingly many investors turn to German real estate investments and use DIC’s asset management services.
We think that its fair value is nearly double the current share price and you also earn a 6% dividend yield while you wait for the growth and post-war recovery.
NewLake Capital Partners, Inc. (OTCQX:NLCP):
The entire cannabis sector is today out of favor. Large operators like Trulieve (OTCQX:TCNNF) have seen their share price drop by up to 75%. Interestingly, Cannabis REITs have dropped along with them, despite posting record results.
It is important to understand that, unlike cannabis cultivators and distributors, REITs earn steady rent checks according to long-term leases with annual rent bumps that are agreed on day 1. They essentially provide the infrastructure to the cannabis sector and earn “toll road” like fees that are fixed in advance.
It is a much more resilient business, and, therefore, you would expect them to have escaped the selloff, especially since their results are stronger than ever.
But that would assume that the market is perfectly rational, which of course, it isn’t. The largest cannabis REIT, Innovative Industrial Properties (IIPR), is down 60% in less than a year. Some of its close peers are down even more.
Our favorite cannabis REIT is NewLake Capital Partners.
It is similar to IIPR, but it has many advantages that should lead to even better returns over time:
- It focuses on limited license states, reducing risks;
- It is much smaller in size, resulting in faster growth as it acquires new properties;
- It still hasn’t invested all of its IPO proceeds, providing a predictable path to growth;
- It is just now starting to use debt and has a pristine balance sheet;
- It is even cheaper than IIPR, priced at just 11.5x FFO and a 6.5% dividend yield.
REITs with such strong fundamentals and growth prospects typically trade at materially higher valuations and lower yields. The main reason why NLCP is so cheap is that cannabis is currently out of favor, but the market narrative will change again, and now is a good time to buy shares at a cheap valuation. We expect 50% upside, and, while you wait, you get paid generous income.
These are just 3 REITs among many others that we are accumulating at the moment.