I was going to start out by saying that we live in a “go big or go home” society. But I realized how dated that statement would be.
Considering all the lockdowns, shutdowns, and stay-ins going on, we’re just a “go home” society.
With that said, staying home does mean we have plenty of time to be on the Internet. Which means we have plenty of time to be checking the markets out.
Which means we have plenty of time to be noticing the very high yields REITs are offering.
Very, very high yields, in some cases.
That’s what you get when prices plummet the way they did following the original coronavirus mortality predictions, and then when vast chunks of the national economy are told to shut down for two weeks, and then six weeks, and then two and a half months or more.
Naturally, stock prices go down. And unless the companies in question then cut their dividends, their yields are going to go up.
Very, very far up, in some cases.
That makes for a tempting-looking treat for many people, especially when their portfolios have been brutalized and their brains traumatized. They might not be thinking straight right about now when it comes to yield – which I completely understand.
When you’re broke, you don’t look a gift horse in the mouth. And when you’re starving, you don’t turn down what looks like free cheese.
Our goal is to make sure you don’t get snapped in a trap when you go for that bite.
How It Used to Be
I’ve warned against high-yielding REITs many a time before, including back in mid March. In “Now Is Not the Time to be a High-Yield REIT Investor,” I reiterated something I’d said back in January: That “buying into a high-dividend yield involves taking more risk. There’s never a free lunch when it comes to chasing yield.”
And then I also wrote this:
“Roger Montgomery, sports agent extraordinaire – and therefore someone who knows a thing or two about long-term investments – also has a thing or two to say on the subject:
“‘I have yet to uncover a billionaire investor that achieved their success from focusing on high-dividend yield stocks. (It’s) a little like the salmon that swims downstream; it just doesn’t work over the long run.’
“Yet many investors become speculators during these fearful times anyway. There’s that natural urge to recoup what we lost by any means possible. And so we make decisions that just make things worse in the end.”
I ended that segment by advising, “Let’s avoid that by staying steady anyway, no matter how many skies seem to be falling.”
If I do say so myself, those were wise words at the time. And not just because the markets hadn’t yet bottomed out.
They were close to that point, of course. But nobody knew that at the time.
Here at iREIT on Alpha, we don’t claim to operate with a crystal ball. We work within proven facts, consistently updated information, and logical expectations for the future that come complete with thorough risk evaluation.
It’s that last element that had my team and I pausing. Because we simply didn’t know what to expect. Not for the economy. Not for businesses. Not for stocks.
It was a wait-and-see situation. And so we waited and sat.
How It Is Today
Before I say anything else, let me first acknowledge what happened last Thursday. Like all of you, I’m very well aware of how badly the markets fell.
It wasn’t quite as atrocious as the near-2,000-point drop the Dow saw on March 9, which amounted to a 7.6% loss. But it still was close enough.
Even so, we’re working with three more months’ worth of assessments than we had when I wrote the aforementioned article. We much better understand our “new normal” and what REITs are working with – across the subsector spectrum.
We’ve analyzed, assessed, and reassessed these businesses’ fundamentals and whether they have what it takes to last another three months, six months, or even a year of the status quo. Which, for the record, they probably won’t have to.
We’re also largely avoiding the most problematic sectors out there: Those that provide too little assurances about their futures.
In other words, we’re being cautious. Very, very cautious, fully acknowledging that we can’t completely predict tomorrow, much less how 2020 is going to close.
But we still think that the following companies are worth considering, despite – or perhaps even because of – their elevated yields.
As I implied at the beginning, it’s almost impossible for them not to have elevated yields considering the current crisis they’re working their way out of. As always though, what we want to know is whether considered companies can sustain those yields.
And in these cases, we’re confident they can.
2 High Flyers We’re Buying
Since inception (March 16, 2020) the Cash Is King Portfolio has performed better than expected, generating total returns of just under 36% in just around 120 days. As a result, it’s rather obvious that dividend yields have compressed for most equity REITs, as Mr. Market has become less worried over COVID-19 impacts.
Keep in mind, we hold a few commercial mREITs in our Cash is King portfolio and our strategy to overweight (mREITs) has been a big part of our success. For example, Ladder Capital (LADR) has returned 101.5%, Hannon Armstrong (HASI) has returned 49.6%, Arbor Realty (ABR) has returned 37.7%, and Broadmark Realty (BRMK) has returned 32.7% – all since investing in their shares.
The mispricing in the commercial mREIT sector can be illustrated best below, as the average dividend for the sector was 22.9% in March vs. 4.75% for equity REITs.
Let me provide this same chart in context of the spread between equity REITs and commercial mREITs, in terms of the average dividend yield:
As you can see (above), in January the spread between equity REITs and commercial mREITs was just 374 basis points and today it’s 3 times that, or 917 basis points. What does that tell you?
Let’s take a closer look at three of our top picks.
Ladder has been our top performer, returning over 100% in less than 120 days. Here are a few reasons we have remained bullish:
- LADR has one of the strongest liquidity profiles with over $830 million of unrestricted cash (over half of book value is in cash). The company’s debt ratios stack up better than most other direct competitors. As viewed below, the company’s funding and warehouse lines are exceptional:
- LADR’s liability structure is the most diversified with a variety of funding sources, that includes the most unsecured financing (~35%), with repo financing of around 28% (most peers are 40% or higher, as viewed below):
- LADR’s balanced loan portfolio provides powerful risk mitigation, especially during COVID-19. The company’s hotel and retail exposure is just around 20% (on a combined basis). Also, LADR’s smaller loan sizes (~ average $20 million) limits exposure to one asset (i.e. BXMT’s larger loans are riskier). Keep in mind, loans represent around ~45% of LADR’s business model and are just one part of the multi-cylinder platform (see deeper dive article here).
LADR recently decided to right size its dividend from $.34 per share to $.20 per share (a 41.2% decline), a move we expected, and we knew was priced in. Even with the smashing price appreciation, we see further upside for LADR as the management team has proven it can manage capital calls during a pandemic. Shares now yield 9.8% and analysts forecast core earnings to grow by 35% in 2021. If shares fetch $14 by the end of 2021 (our target), investors could reap to return another 50% (on top of the 100% in less than 120 days).
Another high flyer we’re buying is CoreCivic (CXW), a critical mission prison REIT that invests in correctional facilities (state and federal) and other community assets – totaling nearly 19 million square feet of real estate used by government.
Keep in mind, investing in prisons has political implications, as well as moral hazards, so it’s up to each investor to determine whether or not he or she is comfortable with the concept of profiting from incarceration. As I have said in the past, I stay away from politics (when it comes to writing) and my duty as a real estate analyst is to cover all property sectors.
With that being said, we believe there’s risk to the political and moral arguments, thus we provide a speculative rating on the sector. Now here are a few major reasons we maintain a Strong “Spec” Buy on shares in CXW:
- COVID-19 has shut down the border, and as a result, ICE (Immigration and Customs Enforcement) control has reduced the inmate population (per bed) from around full capacity to 75%. In the short term, this has resulted in no financial impact to CXW, as the company has collected 100% of rents and there are zero credit issues for CXW. Essentially, the reduction in the prison population is directly related to social distancing. We suspect that once the borders open back up there will be a surge in the prison population as it relates to ICE contracts (approximately 28% of revenue).
- CXW has adequate liquidity ($325 million in cash) and the company has reduced its capex (due to COVID-19) by 10%-15%. In addition to cash on hand CXW has around $155 million of capacity on its revolver (and $350 million on the accordion). Leverage based on debt-to EBITDA is 3.85x (trailing 12 months) and there are no debt maturities until October 2022.
- In 2019 CXW’s FFO per share was $2.62 per share and the previous guidance for 2020 was $2.36 to $2.40 per share. The company withdrew full-year financial guidance on April 1 (previously was $2.36 to $2.40) and analysts now forecast year-end 2020 guidance of $2 per share. The dividend is $1.76 per share, that translates into a payout ratio of 88%. Now, keep in mind, there’s only one analyst reporting (using FAST Graph data) for 2021, and this analyst is forecasting FFO per share in 2021 of 20%.
Source: FAST Graphs
As viewed above, CXW could generate extraordinary returns over the next 18 months (annualized returns in excess of 46%), but remember, we consider this pick “speculative” which means higher risk. The 14% dividend yield provides a meaningful harbinger from Mr. Market that investors should proceed with caution.
Regardless of your decision to buy or not to buy shares in either of these REITs, I must emphasize the importance of maintaining sound diversification practices. Remember, it takes just one torpedo to sink a ship!
Sometimes when you fly high, you can touch the sky, but I always encourage investors to practice responsible investing practices which means to overweight your portfolio with quality stocks. In a few days I plan to provide iREIT on Alpha members with a focus article on my core portfolio known as The Durable Income Portfolio.
Author’s note: Brad Thomas is a Wall Street writer, which means he’s not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.
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Disclosure: I am/we are long CXW, LADR, HASI, ABR, BRMK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.