Over the past 18 months, REITs (VNQ) have seen their share prices crash even as their dividends remained stable or even increased:
As a result, dividend yields are now historically high with some high-quality REITs yielding as much as 8%.
And that’s not all. I would add that:
- REIT dividend payout ratios are also historically low.
- Balance sheets are the strongest they have ever been.
- And rents keep growing at a good pace in most cases.
Therefore, these 8% dividend yields are actually sustainable in most cases as they are backed by significant cash flow and strong businesses.
Earning such a high and sustainable yield is very compelling because it means that you only need to get another 2% growth to achieve double-digit total returns, which is very doable for most REITs.
Below, we highlight two such high-yielding opportunities that are buying at the moment:
EPR Properties (EPR): 7.6% Dividend Yield
EPR Properties is a net lease REIT just like Realty Income (O).
These properties can be very attractive investments because their leases are structured in a way to generate highly consistent and predictable cash flow:
- The lease terms are very long at 10-15 years.
- They include automatic annual rent hikes.
- All property expenses, including even the maintenance, are covered by the tenants.
Therefore, this is a very defensive business, and most net lease REITs tend to trade at relatively low dividend yields and high valuations during most times.
But EPR is an exception.
It is today priced at a near 8% dividend yield and that’s despite having a low 75% payout ratio and growing at a good pace.
Why is it priced at such a high yield then?
I suspect that it is because EPR is focusing on a unique niche of the net lease market that’s perceived to be riskier: experiential net lease properties.
It owns mainly movie theaters, water parks, golf complexes, amusement parks, ski resorts, hot springs, etc. – all leased on a triple net basis:
It is true that these individual properties can be somewhat riskier because they could be harder to release in case of a tenant bankruptcy, but the risks are well-mitigated as part of a well-diversified portfolio, and the reward potential is also a lot greater because there is less competition for these assets.
EPR is commonly able to negotiate higher cap rates, greater lease escalations, and safer lease terms, including master lease and corporate guarantees to mitigate risks. This is how it has managed to significantly outperform the broader REIT market over the long run:
So EPR’s unique investment strategy is clearly working.
In fact, it has been one of the most rewarding REIT investments of all time.
But today, the company is priced at a low valuation because the pandemic caused significant pain and hurt its market sentiment. For a while, its properties were closed, some tenants couldn’t pay their rent, some went bankrupt, and many wondered if theaters would ever recover.
These risks are today still hurting the company’s image… but in reality, the pain was only temporary and EPR has already recovered.
Its cash flow is now nearing its pre-covid levels, some of its tenants have restructured their finances and become a lot stronger, the movie theater box office has made a strong comeback, and yet, EPR remains priced at a steep discount:
We think that this is an opportunity.
The market has failed to recognize that the pandemic was a “temporary” crisis for EPR and it remains priced as if it was facing significant risks, which explains the near-8% dividend yield.
But in reality, the company is now doing well and has guided for 9% FFO per share growth in 2023. Rents are rising and EPR is acquiring new properties.
As such, you get both with EPR: one of the highest dividend yields and one of the highest growth rates in the REIT sector. We think that the market will still take a while to realize that theaters are here to stay, but as more Barbie and Oppenheimer-like blockbusters come out, EPR’s market sentiment will eventually reflect this and the market will reprice it at a higher valuation.
Are there risks? Sure… But these risks are well-mitigated and more than priced in it seems. Remember that EPR is just a landlord, not an operator. It earns rents from long-term leases with positive rent coverage and automatic rent escalations. As long as its tenants can turn a profit, EPR will get paid first, and that’s a much safer position to be in.
Healthcare Realty (HR): 7.6% Dividend Yield
HR is the leading medical office REIT. It owns clusters of Class A buildings in some of the fastest-growing markets in the US and it enjoys highly resilient fundamentals with steady organic growth prospects.
Here is an example of a cluster they own:
Here you can see that their top markets are some of the fastest growing:
And here is the proof that HR owns some of the best locations in its peer group: its properties are in dense locations with high and growing demand. Welltower (WELL), the blue-chip healthcare REIT, actually tried to buy out HR a year ago, which again indicates that these are very desirable assets:
Well-located Class A clustered medical office buildings enjoy greater barriers to entry, limiting the impact of new supply, but their demand is growing rapidly as a result of the aging population and the increased use of outpatient facilities:
Despite all of this, HR’s share price has performed very poorly over the past year as if it was facing a severe crisis, and as a result, it is today priced at an exceptionally low valuation for a REIT that owns such desirable assets.
The market appears to be concerned about the recent lack of growth and the higher leverage.
But this is all now changing.
The management believes that its growth will accelerate to 5-7% in 2024:
We see a clear path to generating FFO per share growth of 5% to 7% in 2024. This potential is bolstered by long-term rising demand for health care services and health systems are reporting that demand for outpatient services is accelerating. We also see near-term tailwinds that could strengthen our growth outlook including market expectations for softening inflation and lower short-term interest rates in the months ahead. These tailwinds align well with Healthcare Realty’s post-merger strategic initiatives.
Moreover, their leverage is now also coming down.
HR’s debt is conservative based on its LTV of 36%, but it is a bit on the high side based on cash flow with a 6.6x debt-to-EBITDA. The reason for this is that Class A medical office buildings trade at low cap rates.
I don’t think that this leverage is an issue. When you own defensive assets that enjoy steady growth, you can use a bit more leverage, especially when you have well-laddered debt maturities. Note that HR has no debt maturities in 2023 or 2024 and very limited maturities in 2025:
But in any case, the market does not seem to like this and so the management is planning to lower its leverage given that we are now in a higher interest rate environment.
The nice thing here is that it can achieve this organically. Its rapid same-property NOI in 2024 and 2025 will bring its leverage down to the low 6s on its own:
Above average same-store NOI growth moving into ’24 will also help to drive leverage lower. As a rule of thumb, every 1% growth in same-store NOI reduces debt to EBITDA by over 5 basis points. For example, 5% NOI growth next year would reduce leverage by over 1/4 of a turn.
Here you have a REIT that owns defensive Class A medical office buildings that enjoy rapid growth prospects and has a rapidly improving balance sheet.
And yet, it is priced at a large 35% discount to its net asset value and a 7.5% dividend yield with a 77% payout ratio.
I would add that this net asset value estimate is more certain than others because HR has been closing JVs and selling properties at valuations that were materially higher than what its stock is trading at.
Moreover, Welltower offered to buy HR last year at $31.75 per share and the fairness opinion of various advisors put HR’s fair value at around $31 so we have real evidence that its NAV is materially higher than its current share price of $16.50.
Finally, HR’s board of directors recently also announced a $500 million buyback program and insiders are buying shares, providing even more evidence that the discount to NAV is real.
A large discount coupled with a high 7.6% dividend yield and rapid growth is very attractive on its own, especially coming from a relatively defensive REIT, but what really makes this a “Strong Buy” today is the numerous catalysts that it enjoys.
The acceleration in its growth and the resulting deleveraging and improving dividend coverage should really help the company’s market sentiment in the coming years and eventually allow it to reach a higher valuation. We expect 30-50% upside from here and ~12-13% annual total returns from the yield and growth while we wait.
Many REITs are down very significantly and now offer some of their highest yields in history.
We are capitalizing on these opportunities because REITs always eventually recover and we don’t think that this time will be any different: