REIT Total Return – Heading into the 2nd Half of 2023

While many of the stocks in the REIT Total Return Portfolio (RTR) are new, there are others that have been in here for a while.  In order to avoid redundancy, we like to examine them from a different lens each quarter.  The focus of this review is going to be multiple neutral returns.

We cringe when people reference market price as a barometer for how well a company is performing.  Quite often the market price performance is driven by multiple expansion or contraction rather than actual fundamental performance.  If a stock price is soaring but earnings aren’t moving that is just the stock becoming overvalued.  We see that as a time to sell while those looking at market price as a performance metric are led to believe the company is doing great.

A much more accurate way to measure a company’s performance is to look at its multiple neutral return.  In other words, how much would it be returning if the multiple stayed the same.  Mathematically, this return works out to dividend yield plus FFO/share growth.

If a company paid a 5% dividend yield and grew FFO/share by 7%, the multiple neutral return to shareholders is 12%.  In my opinion, such a company is performing well for shareholders.  These are, in fact, the parameters the company has control over.  Their operations determine their earnings, and the board determines how much of those earnings to pay to shareholders.

However, over the course of that year, perhaps the FFO multiple at which the stock trades is down from 15X to 12X.  Then, despite the FFO growth, the market price is down resulting in a disappointing total return to shareholders.

That is the point at which the market has a tendency to give up on stocks.  The company is deemed weak despite fundamentally good performance because its contracting multiple hurt historical returns.

That is also the point at which we really like to buy:  Good companies with strong historic and forward operations that have been dismissed due to market price action.

The beautiful thing about buying at the lower multiple is that it enhances returns in 2 ways:

• The forward multiple neutral return is higher due to higher cash flow yield
• Opportunity to capture multiple expansion.

Quite a few things in the market are mean reverting.  With regard to pricing, earnings multiples are the mechanism behind that mean reversion.  It is like a rubber band and the further the multiple deviates from the “correct” multiple, the more tension arises pulling it back toward the correct multiple.

When a stock is trading at too cheap of a multiple, its return outlook is enhanced and it becomes too good of reward relative to its risk level.  As the market realizes the outsized opportunity, its multiple is pulled back up to the proper range where its reward/risk is more in-line with that of the market.

In the following sections we want to discuss how this concept relates to REITs and to the RTR portfolio.

REIT multiple expansion opportunity

The last 7 years have had rather weak REIT returns at an index level, but a quick look at REIT FFO multiples shows the multiple has dropped significantly.  With REIT multiples now at extreme lows there is quite a bit of tension pulling multiples back up.

RTR multiple expansion opportunity

We have consistently focused on relative value and therefore buying the stuff that is trading at the greatest discount to fair value.  When the REIT index as a whole is trading around a 20% discount to fair value, there are individual names within it trading at far greater discounts.  The distribution of REIT multiples forms a bell curve, but it is not quite normally distributed.  It is more platykurtic and has been for a while due to the market’s sector bias.

With this sort of distribution, there are dozens of REITs trading at wider spreads to fair value than the already large gap between the REIT index and fair value.  RTR consists of a diversified basket of those trading at the greatest discounts to fair value.

The REIT index has a 15.89X multiple which is mostly reflective of large caps while our REIT Total Return portfolio has a 12.5X multiple which is more in-line with the median REIT.

Historically, we have had a significantly lower multiple than the median REIT, but right now we are seeing more opportunity in quality upgrades.  We believe we have significantly more quality than the index in terms of growth and risk but due to individual stock selection we are not having to pay up for that quality.  This shows up in the sector weights.

High growth sectors for REITs are industrial, tech, land, manufactured housing, and biotech.  In each case, our exposure is significantly higher than the index.

We also have reduced exposure to the weaker REIT sectors with 0% in hotels and self-storage and only 1.9% in office.

It is a rare opportunity to be able to concentrate in these growth sectors with just a 12.5X portfolio FFO multiple.  The opportunity is provided by a combination of market dislocation and careful stock selection within the wonky market.  This careful stock selection has helped us outperform over RTR’s 7 years of operations and we will spare no effort to continue doing so.

Performance

RTR commenced trading on 7/1/16 with $100,000.  Little did we know, the next 7 years would be multiple contraction years for REITs.  The REIT index is down in price over the 7 years ended 6/30/23 with the entirety of the return being dividends. The MSCI U.S. REIT index returned 27.02% in the 7 years ended 6/30/23 while RTR returned 55.22% net of fees.

We attribute the outperformance to our continuous examination of relative value.  Over the years we have made it a practice to swap out of appreciated stocks and buy those trading at the steepest discounts.

Thus, while the REIT market as a whole was suffering from multiple contraction, we tended to be in the stocks where the multiples were already contracted.  From the already discounted state, there was greater mean reversion tension preventing the multiples from continuing to drop.

Going forward

Over the coming months or perhaps years we think there will be multiple expansion for REITs to more normal levels.  This could tack on some nice capital appreciation on top of the multiple neutral returns REITs are generating from their growth and dividends.

We are positioned to capture the gains by being in the stocks trading most discounted to their fair value such that if they do trade up to fair value the adjustment gains are maximized.

Important Notes and Disclosure

Material Market and Economic Conditions.   March 2022-2023: Significant increases in the Federal Funds Rate by the Federal Reserve have caused REIT market prices to decline more than the broader markets. REITs rely on debt financing to acquire properties and fund their operations; expiring lower-cost debt is being refinanced at higher interest rates due to prevailing market conditions. March 2020: REIT Total Return’s value declined substantially as COVID shut down the economy.  It recovered in 2021 as the economy reopened.  January 2019: Tax-loss selling’s calendar expired and the government reopened on January 25, 2019. The combined effect caused our shares to rise more than the broader markets.  December 2018: Another Fed-Funds rate hike, unresolved US-Chinese trade, a partial government shutdown, and an exaggerated tax-loss selling season put extreme downward pressure on equity prices.  All of these factors contributed to diminished liquidity and more significant share price declines in small-cap/value issues; REIT Total Return is focused on small-cap/value issues, so our decline was significantly more precipitous.

Material Conditions, Objectives, and Investment Strategies.  REIT Total Return is an actively managed investment portfolio of real estate equities, primarily common and preferred shares of REITs, with an aim to generate high total returns from a mix of dividends and capital appreciation.

All REIT Total Return Portfolio performance information on this page is based on the performance of the Portfolio Manager’s account, using the manager’s own funds. Performance of the Portfolio Manager's account is calculated by Interactive Broker on a daily time-weighted basis, including cash, dividends and earnings distributions, and reflects the deduction of broker commissions (when commissions were charged). Actual client returns will differ. **2nd Market Capital’s advisory fees are simulated and applied retroactively to present the portfolio return “net-of-fees”.

None of the performance information displayed on this page is based on the actual performance of any 2MCAC client account investing in this portfolio. The performance in a 2MCAC client account investing in this portfolio may differ (i.e., be lower or higher) from the performance of the account managing this portfolio and portrayed on this page based on a variety of factors, such as trading restrictions imposed by the client (resulting in different account holdings), time of initial investment, amount of investment, frequency and size of cash flows in and out of the client account, applicable brokerage commissions (when commissions were charged), and different corporate actions. Clients investing in this portfolio may view the actual performance of their investment in this portfolio by logging into their Interactive Brokers account and reviewing their customized dashboard.

Clients may restrict any of the securities traded in their account but should note that any restrictions they place on their investments could affect the performance of their account leading it to perform differently, worse or better, than (a) the above-portrayed account or (b) other client accounts invested in the same portfolio.

Forward-looking statements. Commentary may contain forward-looking statements which are by definition uncertain. Actual results may differ materially from our forecasts or estimations, and 2MCAC cannot be held liable for the use of and reliance upon the opinions, estimates, forecasts, and findings in these documents.

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 commentary 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.

Use of Leverage or Margin. REIT Total Return Portfolio will utilize margin only for trading purposes (the ability to use the proceeds from stock sales immediately for new purchases instead of waiting for settlement), but not for borrowing purposes.

Benchmark Comparison. Our REIT Total Return Portfolio is compared to the Dow Jones Equity REIT Index and the MSCI U.S. REIT index because they are common REIT Indices.   The Dow Jones Equity All REIT Index is designed to measure all publicly traded equity real estate investment trusts (REITs) in the Dow Jones U.S. stock universe. The MSCI US REIT Index is comprised of equity real estate investment trusts (REITs) eligible included within the eight Equity REIT Sub-Industries of the Equity Real Estate Investment Trust (REITs) Industry. It is not possible to invest directly in the Dow Jones Equity All REIT Index or MSCI US REIT index.  Index returns do not represent the results of actual trading of investible assets/securities. Index returns do not reflect payment of any sales charges or fees an investor may pay to purchase the securities underlying the index. The imposition of these fees and charges would cause the actual performance of the securities to be lower than the Index performance shown. The results portrayed include dividend income. Our REIT Total Return Portfolio may include REITs that are not eligible for inclusion in the Dow Jones Equity All REIT Index or MSCI US REIT Index.

There can be no assurance that a benchmark will remain appropriate over time and 2MCAC will periodically review the benchmark’s appropriateness and decide to use other benchmarks if appropriate.

Expenses.   Returns reflect the deduction of any transaction expenses. REIT Total Return's advisory fees are simulated and applied retroactively to present the portfolio return “net-of-fees”.

Calculation Methodology.   Returns are calculated by 2MC with data from Interactive Brokers LLC using the Modified Dietz method, a time-weighted measure of performance in which cash flows are weighted based on their timing.    Dividends in REIT Total Return are reinvested.

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