At first look: REITs appear cheap by traditional valuation metrics, leading many to recommend that investors should buy the sector.
Below the surface: The REIT universe is bifurcated between extremely expensive large cap tech companies, and extremely cheap lodging and retail REITs.
Nuance needed: The direction of fundamentals is equally, if not more important, than valuation, and fundamentals are currently headed in the wrong direction. Thus, beware value traps.

The great sell-off of 2020

In times of distress, it can be instructive to look forward and imagine how the current environment might be viewed retrospectively. Will 2020 be viewed as the year of the great March sell-off that was an incredible buying opportunity? Or will future generations remember the global pandemic that plunged the world economy into a synchronized recession – and March was just a taste of things to come?

With REITs about 30% off their peak, many pundits and portfolio managers are taking a fresh look at the sector, using the rationale “REITs are cheap” to justify new positions or “buy” recommendations.

How cheap are REITs? And how do we know REITs will not get meaningfully cheaper before they move higher? A deeper look at valuation levels and the direction of fundamentals paints a picture that is less rosy than a surface level analysis of the sector.

In our view, investors are better off waiting and watching than jumping into REITs with two feet. Most REITs are either NOT cheap or are experiencing significant deterioration in portfolio fundamentals.

Valuation History: Cheap on the surface

One of the most common REIT valuation metrics is premium/discount to Net Asset Value (NAV). This metric measures the difference between REIT stock prices and the estimated value of their underlying real estate portfolios. This valuation metric has been an excellent guide for timing the REIT market during the post GFC bull market that began in 2009-2010.

See our previous blog post “Timing the REIT market”  (which we published in December 2018) for a more in-depth discussion of the predictive power of premium/discount to NAV.

As can be seen in the chart above, during most of the economic cycle, 10% discounts to NAV (using market cap weighting) for the REIT universe tend to only persist for short periods of time and are often excellent buying opportunities. Using this logic, REITs are currently cheap and today represent an excellent opportunity to buy at a 10% discount to NAV.

When we include recessionary periods, however, this 10% discount to NAV does not look nearly as attractive. During 2008-2009, REITs routinely traded at 20-40% NAV discounts, a level that they touched briefly in March of this year (-30%). For this reason, REITs appear cheap relative to recent bull-market history, but could be considered expensive in the context of a recessionary environment. We will let investors decide which type of environment we are currently in. That decision may be the difference between how they view REIT valuations.

Digging Deeper: The valuation barbell

The primary reason that REITs are not trading at recessionary levels is that some of the largest companies in the REIT universe have rallied fiercely off their March lows. This has created a bifurcation in the REIT universe between the haves and the have-nots. Many of the “haves” (large cap tech-focused REITs) currently trade near all time price and valuation highs, while the “have nots” (hotel REITs, retail REITs) trade much closer to recessionary levels.

Lodging Average uses 2021 AFFO multiples as 2020 AFFO is estimated to be NEGATIVE

The table above illustrates the magnitude of the have/have-not discrepancy using 2020 cash flow (AFFO) multiples. The divergence within the REIT industry shown in this table is glaring. The top 4 tech focused REITs in our universe (AMT, CCI, DLR, EQIX) make up almost 30% of the REIT industry’s market cap, and they trade at a 13x premium to the average REIT. Lodging and Retail REITs meanwhile, trade at less than 10x cash flow, and have shrunk to make up just 11% of the industry’s market cap.

From a fundamental perspective, this discrepancy makes sense. Most lodging REIT portfolios are partially or fully closed, with very little visibility as to when they will re-open. Similarly, most retail portfolios are only collecting fractions of the total rent they are owed, with a high likelihood of a spike in retail tenant bankruptcies.

Data Centers and Tower REITs, on the other hand, have seen little disruption to their businesses thus far, and their size and favorable liquidity profiles make them a perfect safe-haven for investors fleeing businesses more exposed to the coronavirus quarantine.

The Bottom Line: Where do we go from here?

So, are REITs really cheap? Certainly, the lodging and retail REITs are cheap, along with Healthcare and Casino REITs. However, 30% of the REIT universe is trading near all-time highs. Interestingly, buying a REIT ETF or mutual fund gives investors a strange barbell exposure of extremely expensive tech focused REITs and extremely cheap retailers and lodging companies with empty portfolios.

For some investors that may be an attractive combination. We remain skeptical, however, as AFFO and NAV estimates for the entire REIT industry continue to come down. We firmly believe that there WILL be excellent opportunities over the next 6-12 months to buy high-quality REITs at extremely attractive prices. Some of those opportunities exist today, but they are few and far between, despite the 30% drop in REIT prices from their February highs.

Our advice is to wait and watch. As fundamentals come to light over the next 6 months, it will become increasingly clear to what extent REIT portfolios are impacted by the current quarantine. We are still in the early innings of a severe economic contraction, and fundamentals are un-equivocally still moving in the wrong direction. Until we see real improvement in economic and REIT level data, we do not advise buying with both hands despite how “cheap” REITs may appear.

Just remember that the last time the data center REIT, DLR, traded above 25x cash flow was in September of 2008. It then fell 60% during the following 6 months…

For more information regarding individual REITs or Serenity Alternatives, reach out to Martin Kollmorgen (Mdkollmorgen@SerenityAlts.com).

Martin D Kollmorgen, CFA
CEO and Chief Investment Officer
Serenity Alternative Investments
Office: (630) 730-5745

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