Could REITs be the new safe haven?
Despite including a Fed meeting in which rates were hiked 25 basis points along with hawkish dot plots suggesting a Fed Funds rate breaching 3% over the next few years, March has been a favorable month for REITs as the sector has managed to evade the selloff in the broader market with a roughly flat performance. Tech and other sectors which had performed so well in 2016 and 2017 are starting to come back to earth and I think this downdraft will continue given the real fundamental threats to the margins of tech companies along with the high multiples at which these stocks trade.
If capital flows out of tech, I suspect some of it will leave the market entirely, but for those who want to stay invested, some of the money will flow into more durable income plays like REITs and utilities. Overall, I think the downdraft in the broader market is a slight positive for REITs on an absolute basis and a big positive on a relative basis. At the risk of sounding like a broken record, I think now is a good time to be in REITs.
While 2CHYP is a REIT portfolio, it is not invested in REITs as a sector, instead opting for specific stocks. In the present environment, we are particularly excited about the following.
The fundamentally reliable high yielders
GOV and GNL have long term contractual income in a magnitude that is unusually high relative to their market prices. I don’t think either company is creating value, but the market is providing extra value to investors by allowing investors to receive oversized cashflows.
For any given set of cashflows discounting for time and risk will determine the present value. The private real estate market is reasonably efficient at computing present value causing the range of prices for assets to be fairly narrow. Generally, when a company buys a real estate asset, it is within a few percentage points of fair value. While I do not think the management of either GOV or GNL is particularly skilled, the same market price for assets is available to them as to anyone else. For ease of math, let us say one of these companies bought an asset for $100 and it provides a stream of $7 cashflows annually. The private market believed a 7% cap rate to be appropriate for the riskiness of the asset. Given that the risk of government tenanted office buildings (GOV) and primarily investment grade tenanted office and industrial buildings (GNL) has not changed a whole lot, the private market still thinks a roughly 7% cap rate is appropriate.
This is where it gets a bit wonky. The public market thinks a ~10% cap rate is appropriate. Thus, in buying GNL or GOV, one is getting almost exactly the same assets at a ~10% cap rate that are privately traded at ~7%. This arbitrage results in a much larger stream of cashflows which manifests in double digit dividend yields. GNL and GOV have been terrible performers in 2CHYP, but I want to emphasize that the poor performance is in market price, not in fundamentals. Tenants are still paying rent at the contractual rates that were set long ago.
The economically sensitive, low multiple stocks
Hotels and industrials have excellent fundamental backdrops. Don’t take my word for it. Check out the industry reports. Smith Travel Research puts out national data on what has already transpired for hotels in 2018 along with forecasts for the rest of the year. Manufacturing is booming and E-Commerce is continuing to take market share from brick and mortar retail. Both of these factors stimulate demand for warehouses.
The market is fully aware of these macroeconomic factors and in many cases prices the favorable fundamentals into the stocks. This is where stock selection comes in. We aren’t buying the 28X 2018 estimated FFO Terreno or the 27X Rexford. PLYM and STAG have access to the same fundamental backdrop at a fraction of the price with P/2018 estimated FFO of 13.3X and 13.0X respectively. I actually think the class B assets of the 2CHYP holdings are better positioned than the Class A assets of Terreno because PLYM and STAG are insulated from supply. New supply is hitting the $6+ per square foot rent market, not the $4 per square foot market.
Similarly, we are not paying 13.3X 2018 est. FFO for Sunstone or 11.3X for Host Hotels. SOHO and HT have access to the same fundamental backdrop for 6.0X and 8.7X 2018 est. FFO respectively. Further, SOHO and HT are each buying back deeply discounted stock to increase shareholder value.
This is an exciting investment environment and we are pleased with the level of opportunities.
Commentary may contain forward looking statements which are by definition uncertain. We retain no obligation to update or correct forward looking statements should the available information change. Actual results may differ materially from our forecasts or estimations.