The last time REITs were so undervalued it was during the great financial crisis.
Back then, investors feared that REITs would go bankrupt because balance sheets were overleveraged even as we were hit by the sharpest real estate crash ever recorded.
REITs dropped like rocks, but in the end, only one overleveraged mall REIT (GGP) had to file for bankruptcy, and even that one eventually got out of it and recovered most of its losses.
Then interest rates dropped to 0%. Banks slowly started working again. And as the market realized that REITs were here to stay, they nearly tripled in value in the following two years:
Note that this is only the average performance of a market-cap weighted REIT ETF (VNQ). If you dig deeper, you will find many REITs that quadrupled or more in the recovery.
Now in hindsight, we know that it was a spectacular time to invest back then. Everything was deeply discounted due to a temporary crisis, and once the concerns were addressed, REITs quickly recovered and richly rewarded those who had the courage to buy them when others were fearful.
But why am I showing this to you?
We think that REIT investors are today given the same opportunity all over again. If you regret not buying REITs in 2008-2009, consider this your second chance to load up on them.
REITs are again deeply discounted because of a temporary crisis, and as the fears dissipate, we expect several companies to double or even triple in the recovery.
REIT valuations are at the lowest they have ever been, at the only exception of the great financial crisis:
This time, the market isn’t concerned about balance sheets, but more so about rent collection rates, which dipped to unusually low levels during the lockdowns.
But rent collection rates are now already on the rise. Interest rates have again dropped to 0%. A vaccine should soon be ready. And we think that it's only a question of time before REITs recover just like they did in the aftermath of the great financial crisis.
We said this back in late March and prices already are up by 40% since then:
![2 REITs That Could Triple In The Recovery (3) 2 REITs That Could Triple In The Recovery (3)](https://i0.wp.com/static.seekingalpha.com/uploads/2020/9/22/saupload_caf87f844ad943bf580ddf58906cfa31.png)
But there's a lot more upside left in certain sub segments of the REIT market that missed out on the recent rally.
Below we highlight two REITs that have the potential to double or even triple in the coming years. We own small positions in them as part of our Core Portfolio at High Yield Landlord.
Urstadt Biddle Properties: NYC Suburb Essential Retail
Urstadt Biddle Properties (UBA) owns grocery-store anchored shopping centers in the NYC suburbs. It continues to trade at near its all-time lows because it combines retail and NYC exposure, which are both hated by the market:
![2 REITs That Could Triple In The Recovery (4) 2 REITs That Could Triple In The Recovery (4)](https://i0.wp.com/static.seekingalpha.com/uploads/2020/9/22/saupload_d91f743b8d9a937a522813ee5bc2ec5e.png)
We think that it's a one of the best opportunities in today's market. Its stock price would need to almost triple just to return to where it was earlier this year. And unless you think that this crisis will cause irreparable damage, there's no reason to believe that it wouldn't get back there over the coming years.
The market is very pessimistic because it thinks that:
Retail properties are dead,
NYC is on the decline,
And UBA is a low quality REIT.
Let's review each of these claims one by one:
Retail properties are dead...
The COVID-19 crisis accelerated the growth of online shopping and the market is very concerned that the continued rise of e-commerce will lead to a permanent decline in rents and values of traditional retail properties.
However, it isn't quite that simple because not all retail properties are created equal.
Some suffer a lot while others remain very resilient. As an example, a remotely located outlet center that only relies on fashion retailers is heavily exposed to competition from Amazon-like (AMZN) companies.
On the other hand, a neighborhood shopping center that's anchored by a grocery store, restaurants, and other necessitates can thrive even in a highly digital world. This is exactly what UBA owns and it's estimated that more than 80% of its revenue comes from Internet-resistant retail segments:
You can think for yourself. You probably shop on Amazon, but it probably hasn't stopped you from going to the grocery store, restaurants, pharmacy, gym, pet supply store, etc. Some things are just better bought in store.
This does not mean that UBA is completely immune to the rise of e-commerce, but it's much more resilient than the market appears to understand.
NYC is on the decline...
The second concern is that NYC could be on the decline. We discuss this topic in great detail in our recent article and come to the conclusion that NYC will suffer a lot, but rise back, just as it always has.
Now the interesting thing here is that not all NYC locations are created equal. While Manhattan is suffering a lot, the suburbs are actually thriving. There's a "flight to suburbs" happening right now and people are moving to the neighborhoods where UBA's properties are located.
These are some of the richest neighborhoods in the nation. The median household income in a three-mile radius of UBA's properties is the highest of the entire shopping center peer group - even higher than Federal Realty Trust (FRT).
We think that UBA's grocery and other necessity anchored shopping centers are well positioned to benefit from the flight to suburbs. But the market has completely missed this angle because of the "NYC apocalypse" narrative.
UBA is a low quality REIT...
UBA is small REIT with a $350 million market cap and it cut its dividend during the lockdowns. UBA also suffered low rent collection rates in April and May, and despite seeing a clear recovery, it still has a long way to go before cash flow returns to normal. This, combined with the high retail and NYC exposure, has led many to believe that UBA is a low-quality REIT.
Again, the reality is very different.
UBA is well managed, conservatively financed, and it owns high-quality properties. Up until the recent crisis, it had consistently outperformed REIT market averages and even grew its dividend for 25 years in a row:
That's not something that a low quality REIT could ever achieve.
But it cut the dividend right?
Yes, but you cannot blame UBA for it. It was hit with the worst possible black swan (lockdowns) which led to missed rent payments. In that context, it's prudent to at least temporarily retain more capital. Most shopping center REITs fully suspended dividends, so in that sense, UBA is actually outperforming. As we put this crisis behind and rents start flowing again, we expect the dividend to be readjusted much higher. In fact, UBA already doubled the payout from the lowest it was in second quarter. It will probably double again within a year from now.
UBA is a great opportunity
We think that the market has gotten it wrong. UBA is perceived to be a risky NYC-focused retail REIT with high exposure to e-commerce risk and questionable management.
In reality, UBA has all the characteristics of a high quality REIT:
- Clear strategy: UBA is focused on defensive retail properties located in NYC suburbs that are thriving. The clustered strategy allows them to efficiently manage assets and provides a competitive advantage against other investors.
- Conservative balance sheet: UBA has even lower leverage than many of its blue-chip peers and minimal near-term debt maturities.
- Shareholder-friendly management: The insiders own ~20% of the combined equity and have a history of doing what's best for shareholders.
- Superior Track Record: They have managed to increase the dividend for 25 years in a row and outperformed sector peers up until the recent crisis.
We have little doubt that UBA has what it takes to bounce back and recover strongly in the coming years.
Right now, you can buy it at near its lowest valuation ever, and we did not want to miss out on this opportunity. We recently opened a position, representing ~2% of our Core Portfolio. If it keeps dropping, we will buy more of it in the coming weeks.
As the dividend returns to a higher level, we expect to earn an 8%-10% annual yield in the coming years in addition to >100% upside as it returns closer to its pre-crisis levels.
Empire State Realty Trust: Trophy Manhattan Property
Empire State Realty Trust (ESRT) is a small Office REIT and we believe that it's an ideal buyout target for private equity players. This is because:
- It trades at an estimated ~70% discount to NAV, which is one of the deepest discounts in the entire REIT sector.
- It owns the Empire State Building, which is one of the most iconic properties in the entire world.
- Its portfolio is concentrated at ~80% in Manhattan, a location where major private equity players already have significant exposure.
- It has a strong balance sheet and it recently suspended the dividend to maintain financial flexibility and conduct share buy backs.
- Finally, the managers have a lot of skin in the game and behave like real owners who seek to maximize value. As an example, the CEO took a $1 salary in the second quarter.
NAV was estimated at ~$20 per share in 2019. Today, you buy it at ~$6 per share and we suspect that there could be a good amount of interest from private equity players to buy it at ~$12 per share – leaving up to 100% upside potential.
It's difficult to put probabilities on the likelihood of a buyout, but ESRT appears to check all the boxes, and Brookfield (BAM) would certainly be happy to show off the Empire State Building on its investor presentation cover.
If ESRT was bought out, it would lead to a quick gain for shareholders, but even if that never happens, we think that ESRT will richly reward investors in the recovery.
So where is the catch?
ESRT is a great opportunity if you have a 5-10 year investment horizon, but most investors do not have the patience to wait for so long and the next 1-5 year period will be very tough for NYC office landlords.
Vacancies will go up and rents will adjust lower.
The observatory deck of the Empire State Building will take time to recover.
And the market sentiment for NYC office will remain very low, potentially for years to come.
ESRT is going through a serious crisis, most investors don’t have the patience, and therefore, it has crashed to new all-time lows:
![2 REITs That Could Triple In The Recovery (10) 2 REITs That Could Triple In The Recovery (10)](https://i0.wp.com/static.seekingalpha.com/uploads/2020/9/22/saupload_14d6198b81c354dbb19c2db5b2fac336.png)
Following this collapse, we are opening a small position, representing 1.35% of our Core Portfolio.
We are fully aware of there will be great pain ahead, but as landlords, we also recognize that buying iconic assets during times of crisis is a time-tested strategy to earn strong returns in the long run.
At just 1.35% of our Core Portfolio, we are comfortable with the risk that we are taking, and if the share price continues to drop, we expect to gradually build a larger position. Based on today’s information, we give it a high risk rating, and we expect to maintain a small position at less than 3% of our Core Portfolio. Over time, as we see a recovery in rent collections and the observatory revenue, we may revise these ratings and build an even larger position.
Ultimately, if you think that NYC will still be NYC 5-10 year from now, then ESRT is a great deal in today’s market.
Bottom Line
UBA and ESRT are two examples of REITs that remain deeply discounted and offer the potential to double or even triple in the recovery.
At High Yield Landlord, we are value REIT investors and we have positioned our Portfolio to maximize gains in the recovery.
We believe that today is the best time in 10 years to invest in REITs:
- Fundamentals are quickly recovering.
- REIT valuations are still at a near 10-year low.
- Berkshire (BRK.A) (BRK.B) and PE firms haven taken notice of the opportunity.
- The vaccine is a strong tailwind that will help sentiment going forward.
- And finally, the 0% interest rate policy is another major tailwind that will drive valuations much higher in the recovery.
Will all our REIT investments outperform in the recovery?
Probably not. But that's why we diversify. Our Portfolio currently holds 26 positions. UBA represents only 2% of it and ESRT represents even less at just 1.35%. We take larger positions in other companies that are even more attractive than these two.
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