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Buy the Dip: 2 REITs are getting too cheap

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Rates up, REITs down.

That seems to be the name of the game as interest rates rise. And unless you live off-grid in the Alaskan wilderness, you’re probably aware that interest rates have risen significantly this year as the Federal Reserve takes swift (and lately) action to combat high inflation.

Whatever benchmark you use to measure corporate debt costs, it’s clear that the days of ultra-low cost lending are over, at least for now.

Data by YCharts

Given that REITs are required to pay out at least 90% of their taxable income in the form of dividends, most of them do not have a substantial amount of free cash flow. So they constantly have to raise more capital to expand their real estate portfolio. With long lease terms and low contractual/organic rental growth, REITs rely solely on raising capital for growth purposes.

The net debt to EBITDA ratio of REITs falls in the range of 4x to 6x, while the debt to total capitalization is between 30% and 50%.

When interest rates rise, REITs typically fall for three reasons:

  1. Higher interest costs will result when existing loans mature and are refinanced at higher rates.
  2. Newly acquired debt will come at a higher cost, reducing the return on investment in new assets (all else being equal).
  3. Higher bond yields are gradually drawing investors towards bonds and away from REITs (and other stocks) because of the greater degree of security.

Hence the ~3% drop in REIT prices this year:

Data by YCharts

This heavy sell-off has dragged the Vanguard Real Estate ETF (VNQ) back down near the lows of the COVID-19 era. While it’s undeniable that rising interest rates are a headwind for REITs, we think this sell-off is overdue for several reasons:

  • Interest rate movements are, by and large, cyclical, just like the economy. They rarely go straight up or straight down for periods of several years with no significant retracements along the way.
  • REITs are more resistant to rising interest rates than most investors think. Most of them have spent the last few years of low interest rates refinancing and extending the term of their loans.
  • As history has shown time and time again, what could be more important to the fundamental performance of REITs than rising interest rates. rising rentsRents continue to rise for most forms of commercial real estate.
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This major sell-off has provided investors with a rare opportunity to pick up shares of a solid but heavily oversold REIT. Below we highlight two of them.

1. Armada Hoeffler Properties (AHH)

AHH has a diverse portfolio of Class A properties focused on the East Coast, namely the Mid-Atlantic and South East regions. Currently, most of the REIT’s properties are clustered in Maryland and Virginia, but management plans to increase exposure to the fast-growing Sunbelt states of Florida, Georgia and the Carolinas.

The company also has an active development platform with a large pipeline of properties currently under development. For the most part, the properties that AHH prefers to develop are mixed-use centers such as Towne Center in Virginia Beach, pictured below.

Armada Hofler Properties

The center consists of 14 separate lots with office space, shops and restaurants and multi-family residences. These live-work-play environments appeal to both residential and commercial tenants in a self-reinforcing cycle. Commercial tenants want to set up shop and rent office space where people are, and people want to be close to their workplace and shops/dining options.

The occupancy rate of AHH is very high at 97.3%, and although the market does not like the exposure to offices, this type of property has the highest occupancy rate of 97.9%.

And the entire portfolio is currently experiencing strong rental growth. By increasing rents and minimizing cost growth as much as possible, AHH was able to achieve the following NOI growth rates for the same store last quarter:

  • Retail: 7.5%
  • Office: 2.5%
  • Multi-family dwelling: 12.5%
  • Total: 7.4%

The main issue related to AHH for most investors is related to the loan. The REIT has a slightly higher amount of debt, as well as preferred equity.

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AHH Q2 Presentation

In recent months, however, management has made significant progress in extending debt maturities and fixing interest rates where possible. They have been very active in delaying the maturities of their loans and interest rate ceilings so that interest costs can rise significantly.

So we think investors have much less to worry about than the market when it comes to AHH’s balance sheet.

AHH is currently trading at 10x normalized FFO and 12x AFFO. We believe that under normal circumstances, AHH is valued at least 50% higher than the current share price. While you wait to see that benefit, enjoy a nicely covered dividend yield of 6.3%.

2. Whitestone REIT (WSR)

WSR is a retail REIT that owns well-located retail properties concentrated in five Sunbelt markets: Phoenix, Houston, Dallas/Fort Worth, Austin and San Antonio.

WSR Q2 Presentation

These markets boast the fastest population and job growth in the country. Several companies, perhaps most notably Tesla (TSLA), have moved their headquarters and/or operations to Texas in recent years due to the business-friendly tax and regulatory environment.

Last quarter, WSR succeeded in increasing its rents by 20% for renewal leases and 16% for new leases.

That’s a surprisingly strong rate increase!

In addition, most WSR leases are triple net, meaning the tenant is responsible for all property maintenance, insurance and taxes. Meanwhile, the average annual rent increase in these leases is also around 3%. It provides some embedded rental growth while shielding the WSR from inflationary cost growth.

And yet, despite well-located malls, rising occupancy rates and rapid rental growth in some of the country’s best markets, WSR’s share price is down some 40% from its pre-pandemic level. Why?

loan.

WSR had a net debt/EBITDA ratio of 7.9 times in the second quarter. In addition, as of mid-September, most of WSR’s debt will mature over the next two and a half years, leading to significant refinancing risks and uncertainty.

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However, that uncertainty has now dissipated as WSR recently amended and extended its $515 million credit facility and related term loan, changing the REIT’s debt maturity schedule from the top to the bottom chart:

WSR September Presentation

As you can see, most WSR loan maturities are now weighted to the second half of 2020, with sufficient capacity on WSR’s credit line to pay off the remaining loan maturities in full over the next three years if desired. is chooses.

After this transaction, WSR’s new weighted average interest rate on the loan will be 4.65%. This number certainly increased with the restructuring of credit facilities and term loans, but it was by no means catastrophic.

WSR’s balance sheet is now largely risk-free, yet the market still trades on the stock. WSR is trading at a price to FFO of approximately 9x, compared to an expected 2022 FFO of $1.00 per share. This means that there will be no growth in the future, while WSR is in fact growing strongly.

For AHH, we think WSR has done that least 50% above fair value, and while you wait for that bounce to come, enjoy WSR’s 5.2% dividend yield that comes with a payout ratio of less than 50%.

ground floor

Perception is reality, and unfortunately for some REITs like AHH and WSR it may take some time for negative perceptions to fade from the investor community and the reality of their fundamental strengths to become apparent.

While rising interest rates and a potential recession in 2023 bring headwinds, REITs always recover strongly from market downturns, and we don’t think this time will be an exception. AHH and WSR are great buying opportunities for higher income these days And 50% plus upside potential.

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