REITs ... Lessons Learned: Diversification Does The Trick (Coronavirus Or Not)
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I’ve written about the power of diversification before. But considering how the markets are performing these days, it seems very worthwhile to write about it again.
I know investments have been crashing almost unilaterally since Monday, Feb. 24. After the closing bell, CNBC was publishing pieces such as “Dow Plunges 1,000 Points on Coronavirus Fears, 3.5% Drop Is Worst in Two Years.” And “10-Year Treasury Yield Falls to Three-Year Low on Coronavirus Fears, 30-Year Rate Hits Record Low.”
Exactly what coronavirus fears were there? Well, as we learned from every other headline out there that day, it was the end of the world.
The AP heralded how “Virus Pushes Beyond Asia, Taking Aim at Europe, Mideast.”
“Italy’s Coronavirus Lockdown Shows How the Outbreak Is Testing Democracies” was what The Washington Post reported.
CNBC broadcasted “Cramer on Market Plunge: Coronavirus Impact on Companies Could Be ‘More Severe Than Thought’.”
Even The Wall Street Journal got in on it with “‘The City Has Been Annihilated’: South Korea’s Coronavirus Epicenter Is a Virtual Ghost Town.”
The clear and present panic rather reminded me of the headlines from the financial market crash – only with far less rational reasoning behind them.
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It’s Time to Talk About the D Word. And No, It’s Not “Doomed.”
Obviously, the markets have been something less than stable since that fateful February day… despite how there have been no reports that the world has imploded quite yet. For that matter, neither has any single country.
Not even China, where the drama all began.
I wrote about this recently in “The Most Reliable REITs for Retirees: The Coronavirus Edition”:
“… there’s always something out there waiting to go “boo!” I won’t provide you with the full list of bogeymen monsters lurking around potential corners up ahead. After all, the point of this piece is to assure you (and point you in the right direction), not to freak you out any more than you already are.
“While, yes, there are always precautions we should take and future-focused thinking caps we should wear, there’s no point in obsessing over everything that could potentially happen in the future. It would be completely counterproductive.”
I didn’t mention diversification in that particular article since there’s only so much I can cover per piece. But since this is a different article, let’s rectify that previous oversight by reiterating the second-to-last line in that quote:
“… there’s no point in obsessing over everything that could potentially happen in the future.”
I know we think we can somehow better handle life when we obsess. But it’s much better, easier, and more effective – not to mention healthier in a financial, mental, and probably physical sense as well – to simply create a portfolio full of well-researched, carefully tailored, wide-ranging investments.
In other words, you want to amass yourself a diversified collection of money-making and money-saving assets.
That plan does all the obsessing for you, leaving you with little more to do than to sleep well at night, even when everyone else thinks the world is falling apart.
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Proper Portfolio Diversification Is the Perfect Prevention
Again, I fully recognize that the markets across the board have performed miserably this time around. Everything seems to be down these days.
But:
Most stocks are going to recover just fine, if not next week or next month, then still sooner you think.
Some sectors have definitely done worse than others.
For instance, energy hasn’t been looking good as everyone predicts that China will fall off the map, going from a global powerhouse to an abject hovel.
That kind of concern was very evident on Friday, March 6. By the time the markets closed, the S&P 500 had fallen 1.71%. The Dow was down 0.98%. The tech-heavy Nasdaq lost 1.87%. The small-caps collection Russell 2000 dropped 2.13%.
And crude oil? It tanked (pun intended) 9.24%.
Another crisis on another day might hit healthcare especially hard.
Or it could do destructive things to construction.
Or communications.
Or financials.
You just never know. And since you just never know, it’s best to hold onto a proper portion of “everything” to hedge your bets.
An Already Diversified Segment of the Stock Market
That’s one of the reasons I love REITs so much. They offer so much diversity in and of themselves.
Before I say one more word, let me make clear that I’m not recommending you fill up on REITs alone. That’s a bad idea, as evidenced by the financial crisis, where anything housing-related lost a lot of equity.
But REITs still come in all shapes, sizes, and subsectors. For instance, there are:
Healthcare REITs
Self-Storage REITs
Office REITs
Industrial REITs
Cell tower REITs
Mall REITs
Apartment REITs
Triple net REITs
Campus housing REITs
Lodging REITs
Manufactured housing REITs
Timber REITs
Billboard REITs
Commercial mortgage REITs
Prison REITs
Shopping center REITs
Data center REITs
Gaming REITs
Single-family rental REITs
Farmland REITs.
There’s actually more than that, but I’m guessing you get the point.
Investing in REITs can offer access to so many segments of the economy, helping you to spread your risk, and maximize your profits.
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One Big, Happy Portfolio
Even with REITs though – again, I cannot stress this enough – you want to diversify.
For some, that means investing in REIT ETFs like Vanguard Real Estate ETF (VNQ). For others, it means investing in a DIY (do-it-yourself) REIT portfolio.
Hoya Capital Real Estate covered the former topic here. So this article is focusing on the latter, starting with Apple Hospitality (APLE).
Apple is a lodging REIT that owns 231 hotels consisting of 29,535 rooms in 34 states and 87 markets. One of its primary attractions is its commanding scale advantage in the upscale lodging category – with leases to industry-leading brands such as Marriott, Hilton, and Hyatt.
These chains benefit from strong reservation systems and loyalty programs. And APLE’s geographic diversification further reduces portfolio volatility through various cycles.
Even so, shares have dropped dramatically on coronavirus fears:
Source: Yahoo Finance
The monthly dividend-paying stock now yields 9.4%.
We do consider lodging a higher-risk sector. But APLE appears to be positioned to weather the storm. Management has extensive transaction and operations experience, and they can pursue marketplace opportunities thanks to their balance-sheet strength.
As of Q3-19, APLE had:
$1.3 billion of total outstanding debt.
An approximate 3.6% current combined weighted average interest rate.
Weighted average debt maturities of five years.
And its net debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) was just 3.1x – with no significant maturities over the next three years.
During 2019, the company purchased approximately 300,000 shares under its share repurchase program. At an average $14.92 each, the total came to about $4.3 million.
More recently, CEO Glade Knight bought $66k at $13.14 per share.
As one of the largest owners of Marriott- and Hilton-branded hotels, APLE offers a compelling opportunity to capitalize on “deep value” mispricing with highly attractive total return prospects:
Source: FAST Graphs
Shopping Around
Urban Edge (UE) is a shopping center REIT that owns 75 shopping centers concentrated in large metropolitan areas – in some of the most densely populated markets in the country. Sixty-two of the properties (and 90% of net operating income, or NOI) are located in the D.C. to Boston corridor.
UE’s portfolio is impossible to replicate. For instance, Northern New Jersey is one of its largest markets – one of the most supply-constrained regions of the country, with only 11 square feet of retail gross leasable area per capita.
We initiated coverage on Jan. 6 with a Strong Buy, and shares have since declined by 11%, making for an even better buying opportunity.
Source: Yahoo Finance
UE’s shopping centers are anchored by high-volume, value, and necessity retailers. The average supermarket generates $740 per square foot in sales. And the REIT’s top tenants include Home Depot, TJX, Best Buy, Lowe’s, and Walmart.
In other words, it’s got stability on its side. Better yet, it has a number of growth catalysts that support enhanced price appreciation potential.
In Q4-19, UE generated FFO of $36.3 million, or $0.29 per share. And its full-year figure was $147.4 million, or $1.16 per share, compared to $1.31 per share for 2018.
It reported same-property portfolio occupancy of 93.4% in Q4-19, a quarterly increase of 20 basis points (bps) – though an 80-bps drop compared to full-year 2018. That was primarily due to anchor bankruptcies.
The company currently trades at both the most attractive historical relative net asset value and widest implied cap rate spread in the shopping center sector. Given its wide discount and potential for growth, we’re maintaining a Strong Buy.
The dividend yield is currently 6.9%. And we believe there’s enhanced opportunity to generate annualized returns of 25% during the next 12 months.
Source: FAST Graphs
No Moles Here
Iron Mountain (IRM) is considered to be a REIT outlier since it has no direct competitors. We generally compare it to industrial REITs, but it’s also made investments into data centers.
Still, at 63% of revenue, storage remains IRM’s core business, with services representing the remaining 37%. As for its business mix:
Records and information management accounts for 61%.
Data management accounts for 12%.
Data centers is 6%.
Secure shredding is 9%.
Now, as you can see below, shares have fallen 8.9% over the last 12 months:
Source: Yahoo Finance
Although IRM isn’t tied to one particular real estate sector, we consider it one of the most diversified REITs in our coverage spectrum. And its more than 230,000 customers worldwide and millions of boxes stored means something.
The company can essentially pass through increases to its customers, making it less impacted by rising interest rates.
IRM has had only 2% customer turnover in any given year, meaning that 50% of the boxes it was storing 15 years ago are still there today. Plus, IRM's records management continues to deliver steady organic revenue growth and strong margin expansion.
Yet it's still achieving meaningful scale and pursuing faster-growing adjacent business opportunities. This includes emerging markets, data centers, and adjacent business segments.
One primary risk is how it has a non-investment-grade rated balance sheet. In the latest quarter, its lease-adjusted leverage was 5.7x, which was slightly down vs. Q3-19.
All the same, we've modeled IRM to grow adjusted funds from operations (AFFO) by 8% in 2020, and by 5% in future years.
The company plans to reduce its payout ratio (as a percentage of AFFO) to the mid-60% or low-70% range. We consider this “Project Summit” to be an enduring catalyst that should both accelerate organic growth while also increasing scale to drive profit margins.
That driver – plus accelerated adjusted EBITDA growth – puts its long-term targeted leverage ratio at 4.5x-5.5x. We maintain a Strong Buy, with total returns targeted at 25% over the next 12 months.
Source: FAST Graphs
One Last Thought…
Easter is just 35 days away. And while we know the Easter Bunny will likely be making a visit to your house, we must always remember not to put all our eggs into one basket.
Source: IREIT
Intelligent REIT investing boils down to sound portfolio risk management, and we consider diversification to be a critical pillar to success. Just ask the Easter Bunny how he/she sleeps well at night.
He’ll tell you.
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Author's note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.
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Disclosure: I am/we are long APLE, UE, IRM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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Brad Thomas
Mar. 10, 2020 7:00 AM ET
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