2 Once-In-A-Decade REIT Buying Opportunities

Real Estate Investment Trusts (REITs) (VNQ) are today priced at near their lowest valuations in a decade, with many REITs trading at large discounts relative to their fair value of their real estate.

Valuations have gotten so low that even private equity players like Blackstone and Starwood are now aggressively buying REITs.

Just recently, Blackstone (BX) announced another $10 billion REIT acquisition (AIRC), bringing the total to over $40 billion worth of REITs since 2022.

Starwood, on the other hand, bought more shares of Camden Property Trust (CPT) in the last quarter, and its billionaire CEO, Barry Sternlicht, made the following comment about the REIT sector last year:

“There are some unbelievable bargains in REITs. We did the same thing during the pandemic. We bought a dozen stocks all over the world and we had a 70% IRR on that stuff. We are already buying some stuff in the public market…”

– Barry Sternlicht, CEO/Chairman, Starwood, Q3 2023 CNBC Interview

And they are right.

Historically, it has always been a good idea to buy REITs following a market crash, as they have always recovered and strongly rewarded those investors who had the courage to buy them when they were discounted:

But the window of opportunity could now be closing.

See, the only reason why REITs are discounted is the fear that we will remain in a “higher for longer” environment and that interest rates will continue to rise further from here.

But as we noted in a recent report, this appears very unlikely. On the contrary, interest rates are likely to head down to lower levels in the coming years now that we have brought inflation back under control.

According to Truflation, inflation is now already at just 1.8% if you simply adjust the reported data for real-time shelter, and as a result, the market is predicting that interest rates will be about 100-150 basis points lower sometime in 12-18 months from now:

This bodes very well for REITs, but they are today still priced at near their lowest valuations in over a decade:

Here are two once-in-a-decade buying opportunities for you to consider:

EPR Properties (EPR)

EPR Properties is my favorite pick in the net lease property sector right now. This is a net lease REIT that specializes in experiential properties such as movie theaters, golf complexes, ski resorts, water parks, hot springs, etc.

Its unique approach of focusing on experiential properties has historically been very rewarding because there is little competition for these assets, and it has allowed EPR to buy them at high cap rates and with attractive lease terms, which resulted in strong spreads over its cost of capital and rapid growth. To this day, most net lease property investors would rather avoid experiential categories because of the more uncertain releasing prospects in case of a vacancy, but EPR can mitigate this risk by structuring stronger leases (incl. master protection) and owning a large and well-diversified portfolio. The approach is still a bit riskier, but it ends up earning superior risk-adjusted returns in the end over long periods:

But today, its share price is heavily discounted, trading at just 8.4x FFO and an 8.2% dividend yield, because of one primary reason.

The market fears that it is going to face severe losses as AMC (AMC) eventually files for bankruptcy. It is EPR’s second-biggest tenant, representing 14% of its revenue, and if it had to take back these properties, it would be a severe blow to the company.

But this risk is greatly misunderstood.

In short,

1. The AMC lease has already been renegotiated.
2. The recent bankruptcy of Regal led to a higher (not lower) rent.
3. EPR’s theaters are already as profitable as they were prior to the pandemic.
4. AMC has raised lots of capital and will likely raise some more if needed. Therefore, it is far from certain that they will ever need to file for bankruptcy.
5. EPR owns the most productive theaters in the nation, and those are here to stay for as long as people want to watch new blockbuster movies.

Well, EPR’s management finally addressed this risk more directly at the Citi Global Property Conference, and it was very reassuring.

Here is the important section: [emphasis added]

Citi Research Analyst: Smedes Rose

So if AMC were to go through a bigger kind of event, I don’t know a lot about AMC, but when we talk to other clients, there’s sort of this assumption that there’s more to go there. I don’t know if you agree with that. But do you feel like this lease would hold up and not be rejected if there was like a reorganization?

Greg Silvers

We’re very comfortable with that, the last or that this lease would hold up. Again, you probably wouldn’t hear this from most landlords, but beginning in ’20, we’ve been encouraging AMC to file. Again, because clean up your balance sheet. The business is recovering, the business looks nice, you have a bad balance sheet. So we have already done the restructuring with them. Like I said, we did it back in ’20. We’re very comfortable with how we’re going to end up as a result of that.

If you look at it now, in our two large — of our three largest theater tenants, AMC, Cinemark, and Regal, Cinemark and Regal have some of the best balance sheets in the experiential area. I mean, fantastic. They fixed in all their problem. AMC is the only one out there, we’d just relatively like them to go ahead and get it done because that’s how comfortable we are with our lease structure and how important our assets are to them.

So essentially, what they are telling us is that if AMC filed for bankruptcy, it would be positive, not negative to them.

The lease has already been restructured ahead of a potential bankruptcy. This restructuring was done in 2020 in the early days of the pandemic when the uncertainty was at its peak.

Therefore, any future bankruptcy likely wouldn’t materially change the lease. However, it would allow AMC to fix its balance sheet and recover as a much stronger and safer tenant.

EPR’s theaters are already profitable at the property level with a 1.7x rent coverage ratio, and things will only get better in the coming years as the box office continues its recovery. The only issue is their balance sheet, and this is why EPR has been encouraging them to file for bankruptcy to restructure their debts.

With that in mind, it seems illogical to discount EPR so heavily based on this one risk factor. We already knew that the risk was misunderstood, but EPR’s management goes a step further and says this is not a risk, but an opportunity for them.

However, it is true that if AMC filed for bankruptcy, it could still lead to some volatility in the near term, and that is what appears to be scaring investors who aren’t following the situation as closely.

Most investors are short-term oriented, so they simply don’t want to risk owning EPR on the day AMC files for bankruptcy since the headlines would likely push it lower, regardless of the actual implications.

This is why EPR is today still priced at the lowest multiple and highest dividend yield in the net lease sector, even despite enjoying some of the best growth prospects and having one of the lowest payout ratios.

Click to enlarge

When Regal filed for bankruptcy, EPR saw its share price dip to the mid-30s. Today, it is trading at $42 per share, so that would imply ~20% downside risk if a similar sell-off occurred and this is why no one wants to own EPR today. Regal is a slightly smaller tenant than AMC (11 vs. 14% of revenue) for EPR, so all else held equal, the sell-off could be even sharper.

But all else is not equal here.

As we noted earlier:

1. AMC’s lease was already negotiated in preparation for a potential bankruptcy.
2. We now know that Regal’s lease was not materially altered, even despite its bankruptcy. In fact, the rent was increased on most of its properties.
3. EPR is telling us clearly that if AMC files, it will be a good thing for the REIT.
4. Rent coverage ratios have already recovered to pre-covid levels and will continue to rise as more big movies come out in the coming years.

Therefore, I believe that this is an amazing setup for long-term-oriented investors who can focus on the actual fundamentals and ignore the short-term noise.

EPR just hiked its dividend by another 3.6% and guided to grow its FFO per share by slightly over 4% in 2024 (adjusted for the one-time lease cancellation fees received in 2023). The management also reaffirmed that they should be able to keep growing their FFO per share by roughly 4% annually in the coming years without accessing the capital markets and while maintaining their current leverage level.

Moreover, they can drive this growth all while improving the quality of their portfolio as they sell movie theaters and invest in other categories to gradually lower their exposure.

Today, they are getting ~8.5% cap rates on new acquisitions, and they believe that they could sell theaters at around the same cap rate level. They noted at the Citi conference that they expect to start reducing their exposure more aggressively in the coming years: [emphasis added]

Again, that’s definitely part of our long-term strategy is become more balanced in our diversification. So the thought process is to continue. We’ve said we’re not growing, in fact, we’re going to reduce that exposure. But again, what Greg and his team have done through that is kind of produced the highest producing theater portfolio in the industry. If you look at our numbers, we control 3% of the theaters, but we’re probably 8.5% to 9% of the box office. So again, it’s a reflection of the quality of the portfolio and how we were able to put that together. So there will be, as time moves on, interested parties in owning something of that high quality. So as the debt markets kind of start to heal, we’ll look at reducing some of that exposure.

Their exposure was 41% a few years ago. It is 37% today and by the end of this year, it should be around 35% according to their guidance. The management mentioned that they expect to gradually bring it down to 15% and keep in mind that they are selling the weaker, not the stronger theaters.

I believe that this is ultimately the catalyst that will lead to significant upside for shareholders who buy it today. The movie theater exposure is the one fear that’s causing the company to trade at such a low valuation. The rest of the portfolio is today doing better than ever. Therefore, if you now reduce this exposure, the market will not have a good reason to discount EPR anymore.

Combine that with some interest rate cuts, and I would expect EPR to reprice in the 12-14x FFO range in the coming years. That would unlock 50%+ upside and while you wait, you earn a growing 8% monthly dividend yield and the company will keep growing by about 4% each year.

That’s a recipe for strong outperformance, and this is why we want to own more of it. After today’s addition, EPR is now the third-largest holding in our Core Portfolio.

Big Yellow Group (BYG / OTCPK:BYLOF)

Big Yellow Group is my favorite self-storage REIT, and I will keep this one shorter because the thesis is very simple, and I have highlighted several times on Seeking Alpha.

In short, the most rewarding property sector in the US has been self-storage for the past 30 years. Self-storage REITs were able to earn nearly 20% average annual total returns because the concept was growing in popularity and these REITs were able to build new facilities and earn unusually large spreads over their cost of capital:

But now the US self storage market has become highly competitive and future returns are likely to suffer.

However, the European self storage market is still 20 years behind, and I expect Big Yellow to replicate these strong returns by following the same model.

Right now, there is still 10x less storage space per capita in the UK than in the US, but the concept is rapidly growing in popularity. Just like in the US, people also move in the UK… They also go through divorces… Older generations leave a lot of stuff behind… People need to now make space for a home office… etc. Moreover, homes are typically even smaller in Europe and especially so in expensive, highly dense cities like London, where Big Yellow is heavily investing.

As a result, 50% of Big Yellow’s new clients are first-time users. They have typically heard about self-storage from a friend, seen an ad, and/or just driven by a facility and decided to give it a try.

Big Yellow has been capitalizing on this opportunity for the past 20 years, and its early results are very strong. It has been able to earn roughly 15% average annual total returns, even despite suffering a major setback during the great financial crisis. Adjusted for that, its total returns have been closer to 20% annually:

And the interesting thing here is that Big Yellow is still just getting started and I think that it can keep this going for another decade or two.

It is today the leader in the UK, but it is still about 20x smaller than Extra Space Storage (EXR) and Public Storage (PSA) in the US.

It currently owns just 100 facilities, and it has another 11 under construction, which should expand its capacity by 15-20% in the coming years. It is expecting to earn a ~9% average yield on these projects, which represents a steep ~300-400 basis point spread over its cost of capital. It also has about as much capacity vacant capacity already built out but not leased yet.

That, plus some organic growth, and a drop in interest rates, bodes very well for Big Yellow in the coming years, but despite that, its share price has crashed along with the rest of the REIT market, and it is today priced at a historically low valuation:

Today, it is priced at just 16.5x FFO, a 4.5% dividend yield, and an estimated 20% discount to its net asset value.

That may not seem that low to some of you, but keep in mind that this is a REIT that has managed to grow its FFO per share by 11% per year on average for the past 20 years and should be able to keep growing at such a rapid pace in the future. Moreover, it has very little debt with a 15% LTV, which also warrants a higher multiple.

So with that in mind, I actually think that Big Yellow is one of the best deals in today’s market. Amongst the REITs that grow at such a rapid pace and use so little leverage, it is offering the best value at the moment and this is why I think that it is a historic opportunity.

Closing Note

REITs are today offering a once-in-a-decade chance to win big, but the window of opportunity could slam shut already in the near term.

If you missed the bargains of the pandemic, this is your second chance to buy real estate at a large discount to its fair value.

I have closely followed REITs for over a decade and have rarely seen such deals, so don’t miss out on it.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.