2 High Quality REITs That Are Misunderstood By The Market

FuntapWhenever there is a fundamental shift in economic or market conditions, new winners and losers are born. Back in 2022, when the Fed started increasing the interest rates at an accelerated pace, the rate sensitive asset classes experienced a sharper drop than the ones that can easily pass through higher financing costs and the inflationary pressures to their customer base. A specific asset class that has been negatively impacted by the surge in interests rates and the subsequent strengthening of a higher for longer scenarios is the equity REITs. While there are some relatively idiosyncratic factors that have also contributed in depressing the valuations (e.g., work from home dynamics rendering parts of the office stock obsolete), most of the pressure has stemmed from the elevated duration factor. The logic is as follows – the longer and more fixed cash flows there are in the future, the higher the duration factor, which, in turn, magnifies the asset price response to a changed in the interest rate environment. In the chart below, we can nicely see how the broader REIT market has significantly lagged behind the S&P 500. Plus, the gap has become wider starting from 2022, when the Fed started to hike. YChartsHaving said that, this specific dynamics creates, in my opinion, huge opportunities for REIT investors. The capital movement away from the broader REIT market has automatically introduced more favorable multiples across the board. Granted, quite many REITs – especially those that operate in the office space and have subpar capital structures with near term debt maturities – have been fairly punished. However, there are also many names that have experienced notable drops in their valuation metrics despite the fact that the underlying cash flows have been stronger than ever. On top of this, some REITs are exposed to greater market irrationality factor than others. Usually, these situations are driven by REIT-specific circumstances that have either disappointed the market or increased the risk profile of the business (at least from the surface). In this article below, I will present two such names that, in my opinion, are misunderstood by the market and thus provide attractive opportunity for investors to capture strong returns in the future. Pick #1: W. P. Carey Inc. (WPC) Back in 2023 WPC was on the path towards achieving a dividend aristocrat status by distributing steadily growing dividends for more than 25 years in a row. However, late last year, WPC shocked the market by circulating a message that it will reduce its dividend and spin off the office segment from its books. The objective was clear – to maximize the multiple by simplifying the structure and leaving more capital in the system to accommodate growth going forward. The initial reaction by the market was negative to say the least. Many dividend seeking investors were disappointed and the future of WPC’s performance was also unclear given the reduced portfolio and a signal that incremental divestments remain on the table. As a result of the shift in focus and the spin-off of the office segment, roughly 63% of WPC’s ABR comes now from industrial and warehouse properties. On top of this, WPC generates additional 6% in ABR from self storage operations, making the retail component of the total ABR just above 30%. The balance sheet remains robust at net debt to EBITDA of 5.3x and relatively favorable maturity profile given the ~ $1 billion of cash that WPC currently holds in its books. However, what has changed also is the multiple. As of now, WPC trades at P/FFO of 11.5x, which is similar to what we can observe in the average multiples for the diversified REIT segment (mostly retail driven). Since the multiple has dropped so low, the dividend yield has become rather attractive, reaching 6.6%. Now, the aspect where the market is wrong is what level of multiple it is assigning for WPC. Currently, WPC is priced in line or even below pure play retail net lease REITs, which is like comparing apples to oranges. The fact that about two thirds of WPC’s ABR comes from more richly valued properties that inherently exhibit more resilient cash flows has not been taken into account by the market. For instance, if we look at the 2024 P/FFO multiples for industrial and self storage REITs we will observe valuations in the range of 17.1x and 17x, respectively. This is a huge gap, which, in my opinion, will eventually close as WPC starts delivering notable NOI growth that should stem from higher growth properties in the industrial and self storage space. Pick #2: Realty Income Corporation (O) Realty Income has also been, in my view, excessively punished by the market. While there is no such straightforward gap that can be identified, instead if we put several pieces together we will then arrive to a conclusion that O could be deemed a bargain at the current multiples. The chart below illustrates well how O’s valuation has gone down considerably since the Fed started its interest rate hiking cycle. YChartsAfter seeing this, the question is whether such an extensive drop in the multiple is justified. The answer is no. Let me elaborate on two major reasons why I think so. First, during this time period that is reflected above in the chart, O has actually managed to grow its underlying FFO generation (in most cases even beating the market expectations). In fact, the market itself is currently baking into the cake a positive FFO growth over the next couple of years. Moreover, the FFO estimates for O are materially higher than for sector median. Seeking AlphaSecond, also within this time period, O has become a stronger business by continuing to acquire properties at relatively elevated cap rates that exceed the cost of capital. The most notable transaction was with the Spirit Realty Capital, where after the acquisition, O became the 4th largest REIT in the U.S. This provides not only direct benefits in the form of synergies, but also strengthens O position in the capital market, which is critical in the REIT business. Another element that distinguishes O and is related to its scale and diversification is the exposure towards European and UK markets, where currently the opportunities for accretive M&A are more favorable than in the U.S. In the Q1, 2024 earnings package we could already notice how O is putting its capital at work in a meaningful fashion across the various European and UK geographies by accessing higher cap rates at lower financing costs. As a result of the depressed stock price, but growing earnings profile, Realty Income trades at a very low multiple of 12.5x. Consequently, the dividend yield has also increased to ~6%, which is one of the highest levels that O has experienced in the past 10-year period (excluding a short moment right when the COVID-19 broke out). In my view, once the interest rates start to drop, it will act as a trigger point for the market to reprice O closer to the value of its underlying fundamentals. The bottom line More restrictive interest rates have pushed down the multiples across the entire REIT space with only minor expectation that pertain to mostly data centers. However, if we look deeper into the REIT space, we will notice that there are some high quality assets that have been further mispriced by the market. W. P. Carey Inc. and Realty Income Corporation are two great examples, which carry robust fundamentals and strong capital structures, while having their multiples significantly depressed by the market. Again, peeling back the onion here, we will observe that the discount is just too steep against the backdrop of their fundamentals. I am bullish on both of these REITs, where the waiting process for the thesis to play out is nicely rewarded by relatively attractive dividend yields.

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