The State of REITs: November 2022 Edition

REIT Performance

REITs had a strong partial recovery in October, but remain deep in the red for 2022 with a -20.99% total return YTD. The REIT sector averaged an +8.69% return in October, which outperformed the S&P 500 (+8.1%) and NASDAQ (+3.9%), but fell short of the Dow Jones Industrial Average (+14.1%). The market cap weighted Vanguard Real Estate ETF (VNQ) had a much lower total return than the average REIT in October (+3.51% vs. +8.69%) and remains deeper in the red YTD (-26.83% vs. -20.99%). The spread between the 2023 FFO multiples of large cap REITs (16.4x) and small cap REITs (11.3x) narrowed in October as multiples expanded by 0.4 turns for large caps and 1.3 turns for small caps. Investors currently need to pay an average of 45.1% more for each dollar of FFO from large cap REITs relative to small cap REITs. In this monthly publication, I will provide REIT data on numerous metrics to help readers identify which property types and individual securities currently offer the best opportunities to achieve their investment goals.

Small cap REITs (+12.85%) significantly outperformed in October as they outpaced large cap REITs (+2.92%) by nearly 1,000 basis points. Both micro cap (+7.36%) and mid cap (+8.11%) REITs had more moderate gains. Small cap REITs (-19.21%) are outperforming large caps (-22.30%) by 309 basis points on YTD 2022 total return.

15 out of 18 Property Types Yielded Positive Total Returns in October

83.33% percent of REIT property types averaged a positive total return in October, with a massive 32.22% total return spread between the best and worst performing property types. Single Family Housing (-4.41%), Infrastructure (-0.96%) and Self Storage (-0.20%) were the only REIT property types in the red.

Malls (+27.81%) and Hotels (+18.89%) significantly outpaced the REIT sector as a whole in October, boosted by resilient consumer spending. The U.S. Department of Commerce’s Bureau of Economic Analysis reported in October that consumer spending in both August and September increased by +0.6%, far better than the -0.2% decline in July. Airline passenger traffic has also significantly rebounded and has been a positive driver for hotel fundamentals.

After the first ten months of the year, Student Housing (+14.02%) and Casino (+7.15%) REITs remain the only property types in positive territory. The Student Housing gains came in the first 7 months of the year prior to the only Student Housing REIT being acquired. Infrastructure (-43.26%) is now the worst performing REIT property type year to date, followed by Malls (-35.51%) and Industrial (-34.41%).

The REIT sector as a whole saw the average P/FFO (2023Y) increase 0.8 turns in October (from 11.8x up to 12.6x). The average FFO multiple expanded for 81.25% of property types, contracted for 12.5% and held steady for 6.25%. There are no recent 2023 FFO/share estimates for either of the Advertising REITs or any of the Timber REITs. Land REITs (27.5x) trade at the highest average multiple followed by Manufactured Housing, Industrial and Data Centers, all three of which trade at an average multiple of 18.6x. Mall (5.2x), Office (7.7x) and Hotel (8.3x) REITs are the only property types currently trading at a single-digit multiple.

Performance of Individual Securities

Duke Realty (DRE) was acquired by Prologis (PLD) on October 3rd in an all-stock transaction. Duke Realty shareholders received 0.475 shares of PLD for each share of DRE owned. Duke Realty’s Chairman and CEO James Connor joined the Prologis Board of Directors.

Bluerock Residential Growth REIT (BRG) was acquired by Blackstone Real Estate Partners IX L.P. on October 6th for $24.25/share in an all-cash transaction. The single-family home portion of the BRG portfolio was spun off as a brand new REIT named Bluerock Homes Trust (BHM), which the initial press release describes as follows: “BHM’s initial portfolio consists of interests in approximately 4,000 homes, comprised of 2,300 operating homes, of which roughly 1,800 and 500 are scattered-site/clustered and build-to-rent, respectively, as well as 1,600 additional homes held through preferred equity and mezzanine loan investments, of which 500 are stabilized and 1,100 are under development/lease-up.”

Service Properties Trust (SVC) (+60.43%) soared after announcing a quarterly dividend raise from $0.01/share to $0.20/share on October 13th. SVC was able to raise the dividend due to amending an agreement that governs its revolving credit facility. This amendment eliminated restrictions on the common dividend and expanded flexibility regarding the issuance of secured debt. The announcement of the improved financial flexibility and dramatically increased dividend elicited a strong positive response from the market.

Power REIT (PW) (-17.99%) continues its 2022 freefall, underperforming all other REITs both in October and YTD (-87.30%). A brutal combination of tenant issues has decimated investor confidence in the REIT. Power REIT has been engaging in a number of agreements in which Chairman and CEO David Lesser is involved on both sides of the table. Multiple properties (including their largest) are now leased to Millennium Sustainable Ventures Corp. (OTCPK:MILC), in which David Lesser owns a sizeable stake and serves as CEO and Chairman. Additionally, tenant quality has become a bigger problem in 2022 with Power REIT pursuing evictions in multiple properties.

81.10% of REITs had a positive total return in October, but only 14.29% are in the black year to date. During the first ten months of last year the average REIT had a +30.93% return, whereas this year the average REIT has seen a -20.99% total return.

Dividend Yield

Dividend yield is an important component of a REIT’s total return. The particularly high dividend yields of the REIT sector are, for many investors, the primary reason for investment in this sector. As many REITs are currently trading at share prices well below their NAV, yields are currently quite high for many REITs within the sector. Although a particularly high yield for a REIT may sometimes reflect a disproportionately high risk, there exist opportunities in some cases to capitalize on dividend yields that are sufficiently attractive to justify the underlying risks of the investment. I have included below a table ranking equity REITs from highest dividend yield (as of 10/31/2022) to lowest dividend yield.

Although a REIT’s decision regarding whether to pay a quarterly dividend or a monthly dividend does not reflect on the quality of the company’s fundamentals or operations, a monthly dividend allows for a smoother cash flow to the investor. Below is a list of equity REITs that pay monthly dividends ranked from highest yield to lowest yield.

REIT Premium/Discount to NAV by Property Type

Below is a downloadable data table, which ranks REITs within each property type from the largest discount to the largest premium to NAV. The consensus NAV used for this table is the average of analyst NAV estimates for each REIT. Both the NAV and the share price will change over time, so I will continue to include this table in upcoming issues of The State of REITs with updated consensus NAV estimates for each REIT for which such an estimate is available.

Takeaway

The large cap REIT premium (relative to small cap REITs) narrowed in October and investors are now paying on average about 45% more for each dollar of 2023 FFO/share to buy large cap REITs than small cap REITs (16.4x/11.3x – 1 = 45.1%). As can be seen in the table below, there is presently a strong positive correlation between market cap and FFO multiple.

The table below shows the average premium/discount of REITs of each market cap bucket. This data, much like the data for price/FFO, shows a strong, positive correlation between market cap and Price/NAV. The average large cap REIT (-14.20%) trades at a double-digit discount to NAV, while mid cap REITs (-20.70%) trade at less than 4/5 of NAV and small cap REITs (-29.85%) trade slightly over 70% of NAV. Micro caps on average trade at a little over half of their respective NAVs (-46.08%).

The fixed-charge coverage ratio, measured as recurring EBITDA divided by the sum of interest expense and preferred dividends, can be a great barometer for the strength and security of a REITs balance sheet. A high fixed charge coverage ratio demonstrates that a REIT will be able to continue to pay its fixed charges even if there was a moderate reduction to its EBITDA (economic downturn, tenant problems, etc.) or a moderate increase in its fixed charges (such as an increased interest expense due to rising floating interest rate). A REIT with a low fixed-charge coverage ratio, however, could quickly find itself in trouble and unable to pay its obligations if either of these metrics moved in the wrong direction.

Median fixed-charge coverage ratios vary significantly by property type with Industrial REITs in the strongest financial position with a remarkable LTM fixed-charge coverage ratio of 7.0x. Although fundamentals for Industrial are currently phenomenal, Industrial REIT balance sheets are strong enough to endure a downturn were one to occur in the near future. Hotel and Diversified REITs have the weakest fixed-charge coverage ratios at 2.4x and 3.0x respectively with the ability to only endure more modest changes to EBITDA or floating interest rates.

Usage of variable-rate debt varies greatly between property types but is currently below a median of 20% of total debt for every REIT property type. Health Care currently has a median variable-rate debt utilization of just over 18%, which is three times that of Specialty REITs which have a median of about 6%. It is important to note, however, that these medians do not showcase the variance within each property type. There are REITs within these property types with significantly higher or lower utilization of variable-rate debt as well as substantially better or worse coverage ratios.

Interest rates have rapidly risen in 2022 and more Fed rate hikes are expected over the short to medium term. This has caused a similarly rapid increase in the interest rates of variable rate debt. For REITs with 100% fixed rate debt, rising rates only impact new loans that are signed. However, for REITs with a high portion of variable-rate debt, their cost of capital has been severely impacted. This has sharply driven up their interest expense and driven down their fixed-charge coverage ratios. Ashford Hospitality Trust (AHT) has by far the highest utilization of variable-rate debt at 91.7% of total debt. Struggling mall REIT Pennsylvania REIT (PEI) has fallen to an LTM fixed-charge coverage ratio of only 0.7x, due in part to the significant increase in cost on their variable-rate debt that accounts for over half of their total debt.

As a result of the cumulative impact of the recent Fed rate hikes, many REITs will need to refinance maturing loans at a higher interest rate. However, for most REITs this impact will not be meaningfully felt in the short term as REITs have a median of only 7.4% of debt maturing before the end of 2023. Not all REITs have managed their balanced sheets responsibly, however, and there are 5 REITs with more than half of their debt maturing in 2H 2022 or 2023. These REITs are AHT with 86.8%, PEI with 78.9%, Sunstone Hotel Investors (SHO) with 67.3%, NETSTREIT (NTST) with 56.8% and Braemar Hotels & Resorts (BHR) with 51.4%. All of these REITs are currently utilizing variable-rate debt for the majority of their debt. Regardless of whether they continue with variable-rate or switch to fixed-rate, they will need to re-finance a majority of their debt at an unfavorable interest rate. Many of their REIT peers instead locked in low interest rate long-term fixed-rate debt in the years prior to the Fed rate hikes and will be able to retain an attractive weighted average interest rate for years to come. This illustrates the importance of a well-managed balance sheet. A thorough examination of a REIT’s (or any company’s) balance sheet is essential before making an investment.

Important Notes and Disclosure

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Past performance does not guarantee future results. Investing in publicly held securities is speculative and involves risk, including the possible loss of principal. Historical returns should not be used as the primary basis for investment decisions. Although the statements of fact and data in this report have been obtained from sources believed to be reliable, 2MCAC does not guarantee their accuracy and assumes no liability or responsibility for any omissions/errors

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Through October 2021, The State of REITs was published exclusively on Seeking Alpha by Simon Bowler, Sector Analyst at 2nd Market Capital Services Corporation (2MCSC).  Editions subsequent to October 2021 will be published on this website in addition to other platforms that may include Seeking Alpha.  2MCSC was formed in 1989 and provides investment research and consulting services to the financial services industry and the financial media. 2MCSC does not provide investment advice.  2MCSC is a separate entity but related under common ownership to 2nd Market Capital Advisory (2MCAC), a Wisconsin registered investment advisor.  Simon Bowler is an investment advisor representative of 2MCAC.  Any positive comments made by others should not be construed as an endorsement of the author's abilities to act as an investment advisor.

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