The volatility monster has awoken from its slumber to once again terrorize investors of all stripes. Coronavirus concerns have created havoc in the stock market and put an abrupt end to the 11-year expansion in the US economy. As market psychology has flipped from extreme greed to extreme fear in a matter of weeks, REITs have been caught in the wave of selling, falling to valuation levels not seen since the 2008 financial crisis.
While the broader impact of the coronavirus is not yet fully known, and it’s too early to start betting on a recovery, certain REIT portfolios are trading at fire-sale prices. REITs have fallen 40% from peak to trough since mid-February, with some REITs falling over 60% in the same time period. Real estate prices, in the meantime, have not changed nearly as significantly in such a short period of time.
The result is a REIT market in which 95% of REITs trade at discounts to the value of their underlying real estate, with the median REIT trading at a 43% discount. This indicates that the average REIT is pricing in significant deterioration in fundamentals, and certain REITs are pricing in an outright 2008 style disaster.
But this is not 2008. REIT balance sheets are in significantly better condition than they were into the last recession, the REIT universe is much more diversified, and management teams are much better equipped to deal with a downturn than they were the last time REITs traded at such steep discounts.
In our view, this creates opportunity. It is NOT time to sound the all clear on REITs and buy with both hands. It is still unclear what long-term effects a global pandemic will have on the real estate market. There are, however, opportunities to buy select high quality REIT portfolios at huge discounts. High quality real estate has an excellent track record of surviving economic shocks, and iconic portfolios in the REIT market only go on sale once every few years. For those that want to be a bit greedy when others are fearful, here are two REITs with irreplaceable portfolios and excellent balance sheets trading at highly discounted valuations.
The Office Bellwether: Boston Properties (BXP)
Boston Properties is an office REIT in the US that owns 196 properties representing 52 million square feet of space. Their assets are concentrated in the top tier US markets of San Francisco, New York, Washington DC, and Boston. Their portfolio was 93% leased with an average lease term of 8.2 years as of the end of 2019. BXP has returned 1,346% (that’s not a typo) since its 1997 IPO, which is 3x the return of the S&P 500 and 2x the return of the REIT benchmark. BXP is a prolific developer, recently delivering the now iconic Salesforce tower in San Francisco, one of the most state-of-the-art office buildings ever built.
Boston Properties is also one of the elite balance sheets in all of REITs, sporting an investment grade A- credit rating. The company is about 30% levered, has $645 million in cash on its balance sheet, and $1.5 billion in capacity on its revolving credit facility. BXP’s most recent bond offering was an unsecured $700m 10-year deal done at 2.9%, which represents a cost of capital most real estate owners would kill for.
With an exceptional balance sheet, iconic portfolio, and a management team made up of some of the most respected real estate developers and investors in the world, Boston Properties is a true blue-chip REIT.
That has not, however saved it from the recent REIT sell-off. Like many of its peers, BXP has traded to a valuation level not seen since the 2008-2009 recession. Relative to consensus NAV estimates, BXP currently trades at a 41% discount, good for the widest gap since consensus NAV data started to be collected in 2010. On a multiple basis, BXP trades at 11.6x 2020 FFO estimates, a measure that has rarely dipped below 20x since the 2008-2009 period.
Let’s unpack what this means briefly. Public market investors with patience can currently buy one of the most iconic office portfolios in the country at a 40% discount to its private market value. Let’s say for arguments sake that the value of BXP’s portfolio drops 10% over the next 6-12 months (that would be a large move for such a massive, diversified, institutional quality commercial real estate portfolio). In that instance, BXP is STILL available for a 30% discount to its intrinsic value. Again, the company has not been this cheap since 2009.
Risk Factors: Like any investment, buying BXP at this juncture does carry risks. Office as a REIT sub-sector tends to have fundamentals that are correlated with GDP, as lower economic activity traditionally translates into lower leasing volumes and slower growth. As GDP falls in Q1/Q2 of this year, BXP will certainly see something of a slowdown in fundamentals until the economy gets back on track. On the capital side as well, as credit spreads have widened, BXP’s cost of capital has increased, albeit from a very low level. This will make funding future acquisitions or development more challenging until spreads come back in or the stock price recovers.
Bottom Line: While the impact of the coronavirus is still impossible to determine, it will certainly impair real estate fundamentals in the near term. REITs with high quality portfolios and strong balance sheets have the highest chances of emerging from this economic shock in good shape. Boston Properties as a blue-chip REIT certainly fits these criteria. The portfolio only has 6.85% of its space up for renewal in 2020 (which is below average), with most of that space coming to market in 4Q. At a 40% discount to NAV, we believe a large amount of economic bad news is already priced in.
The Distressed Icon: Host Hotels & Resorts (HST)
Host Hotels & Resorts owns 80 hotel properties comprised of around 47,000 rooms. Their top 40 assets can be described as iconic, irreplaceable hotels located in top tier markets. Host is the only lodging REIT in the S&P 500, and the only lodging REIT with an investment grade rating. As of the end of 2019, Host had $1.6 billion in cash on its balance sheet and $1.5 billion in capacity on its credit facility. Host is also one of the lowest levered lodging REITs, with a debt/EBITDA ratio of 1.9x versus the average for the sector at 5.1x (lower is better). They also have one of the most respected management teams in the lodging space, a team which navigated the recession of 2008-2009.
Simply put, Host has an extremely high-quality portfolio, a pristine balance sheet, and is run by a seasoned team of lodging industry vets. If it also sounds like a blue-chip REIT, that’s because it is.
Since February 21st, however, HST has fallen from $17.38 to $9.31 as of this writing. That’s good for a drop of 46%. According to analysts, Host’s estimated NAV is $21, meaning their portfolio could be sold at roughly $21 in the private market. That means that Host trades at a 55% discount to it’s consensus NAV estimate, the steepest discount since 2010 (as far back as consensus NAV data is available). This means that if Host’s stock price were simply to revert to the value of its underlying real estate assets, the stock would double.
Now NAV is not a perfect metric, and it’s highly likely that consensus NAV estimates will have to be revised lower considering the current economic situation. It’s worth asking the question, however, “how much less is the Host portfolio worth over the long term?” Will hotel fundamentals be permanently impaired by the coronavirus? Possibly, but the portfolio could lose 25% of it’s value, and the stock would still trade at a 25% discount to that new, lower NAV.
The NAV story is corroborated by other valuation metrics. Host trades at a 2020 FFO multiple of 5.5x (think of FFO multiple as the REIT equivalent of P/E ratio), a value the company has not sported since 2008. From a cash flow perspective, HST trades at 6.8x AFFO (cash flow), which is a 14.7% cash flow yield, and assumes AFFO falls 21% in 2020 relative to 2019. Again, FFO and AFFO estimates are likely to continue coming down as analysts revise their numbers, but even if Host can return to 70% of 2019’s AFFO within a reasonable time period, the stock still looks extremely cheap.
Risk Factors: While Host looks cheap from a valuation perspective…this is the most challenging macro environment for lodging in modern history. Across the globe, there is a huge amount of uncertainty surrounding the fate of the hotel industry. Lodging companies in the US are suffering significant losses of business due to the coronavirus pandemic and it’s very unclear at this point when the US economy will return to something resembling normal. In the ideal scenario, the virus is contained within a few months, travel restrictions start to be lifted, and by the end of 2020 Host is back on the path towards normalized occupancy levels. There is a significant chance, however, that the virus situation is not resolved in the short term, and every month that travel is depressed delays the path back towards full earnings and cash flow.
With a very solid balance sheet and ample liquidity, the chances of HST going bankrupt are extremely low, but the chances of an extended period of subdued fundamental performance are real and substantial. EBITDA in 2020 for the lodging REITs could be down between 30% and 50% from 2019, with uncertainty as to how long it will take to re-fill hotels once the economy resumes relatively normal behavior.
Bottom Line: For investors searching for ideas in the rubble of the REIT market, HST represents a high-quality hotel portfolio that is pricing in significant fundamental downside at the current juncture. Risk in the name is elevated, as the range of possible future outcomes for fundamentals is wide. This is evidenced by the extreme valuation discount of the company and its peers. The company does, however, have an extremely high-quality hotel portfolio, an excellent balance sheet, and a management team with significant experience navigating difficult environments. Host is a high-risk play but has a good chance of weathering the current storm.
Martin D Kollmorgen, CFA
CEO and Chief Investment Officer
Serenity Alternative Investments
Office: (630) 730-5745
**All charts generated using data from Bloomberg LP, S&P Global, and Serenity Alternative Investments
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