Retail crowd’s favorite REITs: disappointment likely to continue

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REITs, or real estate investment trusts, are an asset class that is typically followed and bought by investors with a focus on cash flows in the form of dividends. One of the main arguments is that this way they don’t have to bother about stock price fluctuations, as their dividend income is safe. Sounds logical, but the long-term performance of three highly celebrated such REITs is simply weak. The worst thing, I am expecting this trend to continue or even to worsen.

Summary and key takeaways from today’s Weekly
– REITs with long leasing durations are seen by many as core investments for their dividend income portfolios.
– However, exactly these REITs have not only shown a poor performance over the last twelve years, they even are at risk of losing even more.
– Their highly celebrated business model is turning against them as there’s a difference between nominal and real figures.

While it might be unfair to say investing in REITs is just something for beginners, nonetheless for me there’s something to it as especially many beginners do exactly this.

For sure, one can make stellar gains and even outperform the market with REITs.

It is possible. One needs to be very selective and rather pursue the proverbial once in a decade opportunities. As a more recent example, it made sense to have a look at the sub-sector of office REITs during 2023 when everyone and their neighbor thought that everybody will work from home for the entirety of their lifetime (see here).

Those of my members who bought at the time of my exclusive report featuring an office REIT and held until today, made more than 40% in 16 months – plus dividends.

But certainly not by blindly applying buy and hold (of which I have become a bit skeptical, see here), as I will show in this Weekly further below.

As my longer-time readers know, I like to use Twitter as a source to assess investor sentiment, but also to get a feeling for what topics, sectors and of course individual names are currently en vogue. Not to jump on the same bandwagon, but rather as a sign to be cautious and to look elsewhere.

Inside what I like to call the “dividend bubble”, almost self exploratory you will rather sooner than later stumble upon (certain) REITs. They are often seen as the cornerstone of a robust portfolio. While the main argument for dividend investing is that with time the income stream rises and one does not need to care about stock prices in this context, I tend to see it differently.

Dividends might be fine, but not seeing any performance (not even keeping pace with inflation) for a decade or even more is hardly a convincing strategy.

This is exactly what three pretend high-profile names did.

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Better don’t rely just on dividends

I absolutely understand the arguments of dividend investors.

One reason is people are afraid of stock price fluctuations. Thus they try to calm their nerves by motivating themselves to look at the income stream in the form of dividends, not what the stock does. Ideally, this income stream rises through a combination of raised dividends per share plus more stocks acquired, financed by dividends and for example automated savings plans.

Other reasons are they don’t have the knowledge and / or the time or even the ambition to go for a more time-consuming (but more lucrative) stock picking strategy. The approach here is to find stocks of companies which trade below their potential or fair value with the goal to see higher stock prices (and maybe, but not necessarily dividends on top).

This is perfectly fine until here.

Where I do not agree, though, is what looks to be more like lying to oneself. As if this weren’t bad enough, I must say that as someone who writes about stocks and publishes stock ideas myself, I feel somewhat disappointed about these “evergreen”, “must-have” and “core” holdings, many advise to put into the portfolio.

Said more from the evil side, I tend to see such “tips” as signs to stay away.

Of course, nothing can’t go wrong – the arguments are always the same. Proven history of the companies and long and enduring dividend histories with frequent and uninterrupted hikes.

To make it clear what I mean, I am just showing you the stock charts of three very popular REITs over the long-term, as they say more than I can with written words.

source: Seeking Alpha, see here
source: Seeking Alpha, see here
source: Seeking Alpha, see here

We are approaching twelve full years, where the stocks of Realty Income (ISIN: US7561091049, Ticker: O), NNN REIT or National Retail Properties (ISIN: US6374171063, Ticker: NNN) and Federal Realty Investment Trust (ISIN: US3137451015, Ticker: FRT) have done absolutely nothing for their investors price-wise. In the case of the latter, even almost since 2007.

Is this the no-brainer, high-quality everybody’s talking about?

The typical answer would be of course, but they paid and increased their dividends.

This is not false per se. But honestly, wouldn’t you kick yourself, if you knew what the broader markets did since then? I guess being proud of having received some dividends is a very weak solace.

Part of the truth is also that investors who hypothetically held for so long, haven’t received each year the dividend yields that are shown above. These are the current ones after several increases. Back then and during the period until today, they were noticeably lower.

At best the performance is equal to the inflation pre-tax, but rather below.

I know that deep-rooted and convinced-to-the-core practitioners of this strategy would answer that I haven’t considered frequent buy-the-dips and reinvestments. While true, it is also true that many have only started to invest at a later stage, i.e. at worse conditions (higher stock prices at higher valuations and even lower dividend yields).

Thus, what I am writing can only be a gradual approximation. However, trying to see the big picture roughly right is likely the better approach than to be precisely wrong.

In a more aggressive way, I could just say everyone who bought a flat / apartment or a house did much better than these “safer and better” high-quality alternatives.

Anyway, none of the three above has made a new all-time high since at least 2020.

What I wrote until here is the past.

source: F. Muhammad on Pixabay

But the investment environment for these companies has worsened considerably. That’s why I am convinced that these favorites will not only remain dead-money laggards, but they could indeed face more pressure and even lower stock prices.

The main reason is interest rates – but the implications are manifold.

Interest rates affect mortgage rates, bond yields and in general the cost of capital. As we have seen central banks increasing rates to significantly higher levels compared to the “golden era” for REITs post the Great Financial Crisis 2008–2009, the companies obviously are experiencing headwinds now. Not the tailwinds they had in the decade before.

I would like to even go a step further. The years 1980–2022 were paradise for these companies (peak interest rates and continuously falling). This is the period they use for their marketing material to prove what great businesses they are. But the real test comes now.

Operating in their business has become more expensive.

And this despite what many thought lowering interest rates again would be a power-boost for these stocks. Well, the majority obviously must be wrong…

source: Twitter, see here

The time of practically money-for-free is over.

In the past, the ten-year government bond yields were the practical equivalent of the risk-free interest rate. Whether this will be case in the future, remains to be seen (I have some doubts, just see what happened in France, see here or here).

However and back to the US, for now, it is unlikely new debt financing will be possible at much more advantageous terms than what treasuries offer. Respectively, the old rule of “treasuries plus risk premium” has altered entirely the investment environment for REITs. That’s why it would be wise not to look at the former all-time highs as the logical next stop for these stocks.

One should question whether even the current stock prices are not too high.

The thing is, not only has raising debt via mortgages and / or corporate bonds become more expensive. Likewise and as REITs typically do not repay their debt in full, but roll it, the higher cost of debt in the form of interest payments eats into their bottom lines.

Each round of refinancing pressures the profit and loss statement as lower yielding debt gets replaced with (much) higher-coupon bonds. This in return has prevented stocks from rising further as investors are demanding a higher equity yield (lower valuation multiples as the reciprocal value).

But it gets worse better.

As raising equity through share issuances is also part of the game to keep the balance sheet somewhat stable, this route of sourcing capital has likewise become more expensive, respectively less advantageous for equity investors. With lower stock prices, the dilutive effect has become bigger.

All in all, this is a massive step on the brakes with both feet. From the financing side, growth has been almost turned off.

But there’s another component we need to discuss which affects these REITs directly.

source: Mohamed Hassan on Pixabay

REIT fans will have already had that in their quiver against my arguments.

Of course, a well-managed REIT has automatic escalators in their leasing terms, meaning rents automatically adjust, generally on a yearly basis. This has been a hallmark of especially – you guessed it – these REITs.

Long lease durations which allowed for “safe planning” and “predictable rent income / increases” are seen as one of the top arguments for these REITs.

As it turned out, this is exactly what has flipped into a big disadvantage for them now. With this business model of long leases and unfortunately also comparatively low automatic escalators, despite nominal increases these REITs are losing ground on inflation-adjusted figures.

Contracts that were closed before inflation jumped, were usually made on expectations for low inflation, hence low escalators of say 1–2%. Inflation, despite having come down, is still at 3%, give or take. At least the official number. Staffing costs, material, service costs etc. have become much more expensive than that.

Long leasing terms are simply hard to adjust to inflation in the short term.

This initially celebrated as a no-brainer and genius business model, has put them exactly in a position that hurts them now the most.

I am shocked that many don’t see that and let the companies BS them this easily with great dividend series.

source: NNN REIT, see here

source: Realty Income, investor presentation, see here
source: Realty Income, Q3 24 presentation, see here

In this setup, these companies are making real losses, despite presenting their fanbase small improvements on a nominal basis and hiking their dividends symbolically.

If you have an inflationary scenario and want to make a real 7% return, you need to make 10% or better 12% now. The following numbers look like a bad joke in this regard.

source: TIKR

As you can see above, the pace of dividend hikes has slowed. The current level seems to be for O and NNN between 2–3% p.a., while FRT ist completely lagging with below 1%.

Any wonder these darlings are disappointing?

So, are we really having “generational buying opportunities”, almost every day?

Don’t think so.

The risk is more to the downside for these stocks. What sounds unbelievable, is not unrealistic. The most recent inflation numbers showed an uptick again – without energy having risen, respectively contributed much which would be a knock-out.

source: Twitter, see here

I am not quite sure, but this does not look like a good business environment. There’s still the risk that these companies fall towards 1x book value, especially if financing becomes even more expensive, as the recent yield surges have shown.

1x price to book is where I’d consider to get interested, preferably tangible book.

My office REIT pick made it to my member-exclusive research report at 0.7x book. The stock even briefly fell to 0.6x, but then picked up steam. Now it’s trading around 1x book value where I consider it to be fully valued. If from time to time I can spot such opportunities, I clearly don’t need to mess around with such at-best mediocre stocks.

Not all REITs are comparable 1-1. But some sub-sectors can fall out of favor quite dramatically, while others remain on elevated valuation levels.

  • Realty Income trades for 1.3x their book value, but on a tangible basis it’s still 1.8x
  • NNN REIT trades at 1.7x each
  • Federal Realty trades at 3x each
source: TIKR

Clearly no time to hurry!

Federal Realty has a business model and tenant profile that differs a bit from the other two’s. But for O and NNN, I can imagine easily to see prices 30% lower than today. Absolutely, why not if long-term government bonds reach 5% or even over-shoot?

This is something that needs to be watched closely.

I think there will be a brief period to make a bargain. But not at these levels. There are still too many optimists. They need to be shaken out first and valuations need to be on levels one would describe as “once in a lifetime” opportunities.

The time is not now.

Conclusion

REITs with long leasing durations are seen by many as core investments for their dividend income portfolios.

However, exactly these REITs have not only shown a poor performance over the last twelve years, they even are at risk of losing even more.

Their highly celebrated business model is turning against them as there’s a difference between nominal and real figures.

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