REIT Total Return Positioning in a shifting REIT Landscape

The REIT Total Return (RTR) portfolio has been running for over 8 years in a rapidly changing macro environment.  We believe it is important to maintain a consistent underlying investment philosophy to incorporate nuanced opportunities in an ever-changing market.  This update will discuss how we preserve a consistent philosophy while staying flexible.

As a reminder, the key principle of RTR is the pursuit of fundamental quality trading at a discounted valuation.  Within our scope of investments, there are plenty of high-quality companies trading at cheap valuation and our goal is to uncover those that fit both parameters.

That is our enduring philosophy and we hope to communicate how this idea is nuanced for the present environment.

Here is the portfolio-level data:

The valuation delta remains with RTR being about 7 turns cheaper than the Dow Jones Equity REIT index at 13.3X FFO compared to 20.3X for the index.

We like value because it means each invested dollar earns more cashflow allowing REIT Total Return to have a higher aggregate dividend yield of 4.88% compared to the index at 3.56%.  Further, the higher underlying FFO yield allows the companies to retain more cashflow for growth.

Value in the colloquial sense consists of companies that trade at low earnings multiples or low price-to-book ratios.  Many value stocks are cheap for a reason so it would violate our quality principle to just blindly buy low multiple stocks.

Instead, we like to find value by observing large swaths of the market over long periods and buying when individual high-quality stocks become mispriced.  Through this process, we have been able to capture value while having overweight exposure to the higher growth areas of REITs like industrial, retail, manufactured housing, and land.

Marginal cost of quality

It can be tempting to want to own the best.  Certain companies have measurably better fundamentals than others and all else equal we would certainly gravitate toward those companies.  However, one of the major sources of opportunity in today’s market is extreme variance in the marginal cost of quality.

In some sectors, the valuation gap between the companies with the strongest fundamentals and those with mediocre fundamentals is quite small.  In these sectors, the marginal cost of quality is low meaning we can own the best without having to pay an arm and a leg for it.

In other sectors, there is a monumental valuation gap for only slight fundamental quality differences.  In these sectors, we believe it is better overall to invest in the slightly less high quality due to a much better valuation.

Retail – low marginal cost of quality

Among retail REITs, there is minimal variance in AFFO multiples.  A few weeks back we plotted each shopping center REIT’s multiple against its leverage, and you can see below that they are trading within a fairly tight band.

Despite the tight valuation range, there are significant differences in forward growth potential.

So, with the market presenting the opportunity to own high quality without much of a premium, we will happily own the shopping center REITs in growth markets with strong management.

Industrial – high marginal cost of quality

In sharp contrast to retail REITs which trade in a tight band, industrial REITs have huge variance in valuation.

In my estimation, STAG should trade about 3 turns cheaper than EGP, and PLYM about 7 turns cheaper.

However, due to the extreme valuation gaps in industrial right now, STAG is 6 turns cheaper (15.7X versus 21.6X) and PLYM is a whopping 10 turns cheaper (11.6X vs 21.6X).

Thus, in owning STAG and PLYM we are capturing substantially better value with only a slight downgrade in growth.  Both STAG and PLYM have excellent properties and long runways of moderate to strong growth. At the current valuation, I find them hard to pass up.

Forward outlook

While the 10-year treasury yield has moved back up above 4%, the cost of interest expense is still headed downward as that is based more on the short end of the curve.  As such, we anticipate REIT multiples will trend up marginally over time.  We will continue to try to capture mispricing as REIT market prices often bounce around within ranges.

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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