5/15/2019 Why REITs Outperform Stocks, And 3 Strong Buys In May 2019 | Seeking Alpha

REITs

Why REITs Outperform Stocks, And 3 Strong Buys In May 2019

May 15, 2019 10:00 AM ET13 comments | 12 Likes
by: Jussi Askola

Summary

It is well-known that over long-time periods, REITs have consistently achieved higher
returns than stocks and bonds.

We think that the factors that led to this outperformance in the past; remain perfectly
relevant today.

Real estate is a high ROI asset class; REITs invest in them within a tax-advantaged
structure; and pay out the majority of their cash flow in dividends.

Today, after a 3-year long streak of underperformance, REITs are ready to get back
to market outperformance.

We share three of our Strong Buy-rated REITs in May 2019.

Looking for a portfolio of ideas like this one? Members of High Yield Landlord get
exclusive access to our model portfolio. Start your free trial today »

Currently more than 80 million Americans are invested in REITs directly or through REIT
mutual funds or exchange-traded funds (ETFs). This is not surprising when you learn that
the easiest way to outperform markets in the past 30 years, would have been to
overweight REITs in your portfolio.

REITs have consistently generated greater total returns and payed higher dividends, all
while being less risky:

(Source

REIT d k bl li S&P500 li )
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. REITs: dark blue line; S&P500: grey line.)

Counting out the latest 3-year period of underperformance, the return differential is even
more important:

(source)

From 1997 to 2016, REITs (VNQ) generated up to 4x higher total returns than the S&P
500 (SPY).

Yet, still to this day, many remain on the sidelines because they believe that this
outperformance was the direct result of declining interest rates. Now with interest rates
(possibly) back on the rise, they are very skeptical of future performance. In reality:

REITs have outperformed during times of rising and declining interest rates.
REITs may benefit from rising interest rates (leads to higher rents, lower vacancy, and
lesser competition from new constructions.)

Therefore, we strongly believe that the trajectory of interest rates is not the main driver of
the past outperformance. The market seems to forget that every investment benefit from
lower interest rates and that REITs are not the exception. Moreover, REITs are total return
investments; and not bond-like instruments as many seem to believe. Today, this
argument is especially weak because REIT balance sheets are the strongest they have
ever been; and cash flow growth is positive.

We identify 3 more-probable reasons why REITs keep on

outperforming:
1. Real estate is a superior investment asset class.
2. REITs combine the power of real estate with tax benefits.
3. REITs are forced to pay high and consistent dividends. This reduces conflicts of
interest, and increases discipline in capital allocation.

Each factor remains perfectly relevant today and results in mechanically repeatable
outperformance. Therefore, as long as the valuation of REITs remains favorable, we are
confident that REITs are set to continue outperforming stocks in the long run.

Reason 1 – Real Estate is a Very Powerful Asset Class

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We strongly believe that real estate is the very best asset class to generate high total
returns over long time periods. It is not just our opinion; it is also backed by factual
evidence.

Even accounting for the sharpest real estate crash of mankind (2008), real estate beat
stocks with lower risk in the past decades:

This is because the simple math behind a property investment is very powerful:

Buy at a 6-7% cap rate

Finance half of the purchase with a 3-4% mortgage
Appreciates at 2-3% per year (along with income growth)

And you get close to 12-15% annual total returns. It is this simple. The assumptions are
nothing unrealistic and this is done every day by experienced property investors. The
beauty here is that even with these high returns, the risks are not any higher than that of
traditional stock investments. Opposite of that, we argue that such property investments
are much more conservative because:

1. Landlords participate in the profit earned by their tenants through rents that are
contractually guaranteed – often for many years to come.
2. Landlords get paid first. Without a rent payment, a business cannot keep operating
and therefore rents are even senior to debt payments in most cases.
3. In the worst case where a tenant goes bankrupt, landlords can release the same
property to another tenant. The value of the previous tenant’s business may go to 0,
but the landlord is in a much safer and stronger position to sustain value.
4. As a scarce supply and essential part of our infrastructure, real estate provides
i i fl ti t ti i t t i k th t h ld tb l k di t d ’
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superior inflation protection – an important risk that should not be overlooked in today’s
market environment.

The result is an exceptionally strong risk-to-reward outcome for real estate investors;
stronger than that of stocks in our opinion.

Reason 2 – REITs Combine The Power of Real Estate With Tax

Benefits
Unlike regular corporations (stocks) which pay corporate taxes on their net income; REITs
are tax-advantaged vehicles and pass on these large tax savings in the form of higher
returns to their investors.

This alone may account to a 20% income advantage right off the bat. Assuming that two
businesses are equally viable, but one is structured as a REIT and the other as a normal
C-corp, the REIT will generate greater returns by saving massive taxes.

Reason 3 – Forced Dividend Payouts Increase Returns

Finally, REITs must pay out 90% of their taxable income in the form of dividends to
shareholders. This often-overlooked rule creates alpha by:

1. Removing conflicts of interest. It transfers the control of the cash flow from the
managers to the shareholders.
2. Improving the discipline in capital allocation. Since managers do not have a lot of
cash flow to play with; they are less likely to waste it on some low ROI projects.
Rather, they will often have to access the public markets to raise new equity under the
scrutiny of professional analysts.

Moreover, as many research studies

have found: dividends make up a very large portion of total returns. Some say it
contributes 50% to total returns; others find that it results in up to 90% of total returns in
the long run.

The common conclusion is that dividends are a very important component; and that large
dividend payers are likely to outperform non-dividend payers in the long run.

(source
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REITs pay much greater dividends on average; with an average yield of ~4% - roughly the
double of the S&P500 (SPY). Moreover, the average yield of REITs can be easily boosted
by being selective and focusing more on the undervalued small cap segment.

As an example, our REIT Portfolio has an 7.5% dividend yield, despite a low payout ratio
of just 69%, and regular dividend hikes. The higher cash return increases the safety of
total returns. We are legally entitled to most of the cash flow, even during occasional bear
markets; and we are less dependent on stock market appreciation during bull markets.

What About the Next 10 Years?

Every asset class is subject to changing market sentiment in the short run, and REITs
have been out of favor in the recent years due to irrational fears over the rise of interest
rates.

As a result, REITs underperformed in past 3 years:

After the latest underperformance, REITs have significantly less optimism and growth
priced into their share prices - providing greater margin of safety. The same cannot be
said about the most large-cap stocks such as Amazon (AMZN), Alphabet (GOOG), or
Netflix NFLX) which rely on strong growth to continue generating attractive returns from
here.

We are heavily investing in REITs because we believe that they are set for a return to
outperformance in the coming years.

1. Peaking Interest Rates: REITs have suffered from great market pessimism in the past
three years due to fears of rising interest rates. Now that these fears are slowly
disappearing, the headline risk is removed, and investors are returning to REITs.
2. Slowing Global Growth: Moreover, now that growth is slowing down in a late cycle
economy, investors are becoming increasingly interested in more defensive stocks
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with consistent income such as REITs.

As a result of these two themes, we expect REITs to go from:

“avoid at all cost due to rising interest rates”

to:

“buy for defensive income in a low growth environment”

Since the beginning of the year, REITs have already recovered by over 17%, and we
believe that there is more to come:

Three "Strong Buy" REITs in May 2019

While we are bullish on REITs, it is important to recognize that not all REIT are created
equal, and especially today after the recovery, investors must be selective to achieve
strong results.

While the passive indexes may still earn a “hold” rating; we are able to find several Strong
Buys in less crowded, yet more lucrative specialty REIT sectors.

Heading into summer of 2019, we are buying shares of the three REITs presented below:

Company HYL Rating Risk Level Allocation Level

Iron Mountain STRONG BUY Avg Avg

Iron Mountain (IRM) is a "growth-at-ridiculously-low-price" REIT with a solid ~8%

dividend yield that is expected to grow at ~4% per year. The company is operating a
defensive storage business; but after missing on its first quarter results, the shares sold off
heavily. We believe that this is one of the best opportunities right now because the
underlying business model is doing well and the full-year guidance was maintained. From
th di id d d th l tf d bl di it t Add t th t FFO
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the dividends and growth alone, we are set for double digit returns. Add to that some FFO
multiple expansion and the returns could be spectacular for this risk profile.

Company HYL Rating Risk Level Allocation Level

Jernigan Capital STRONG BUY High Large

Jernigan Capital (JCAP) is a relatively new REIT that provides creative capital solutions
to private developers, owners, and operators of self-storage facilities. It is a model that is
different (in a good way!) from equity REITs, but also from mortgage REITs in that it loans
money, receives equity and often provides additional services to borrowers. The results
have been phenomenal thus far with very strong returns on invested capital, and the
pipeline remains large. Sold at just about 7x FFO, we believe that the company is
mispriced by ~40%. While we wait, we earn a well-covered 6.6% dividend yield.

Company Rating Risk Level Allocation Level

Front Yard Residential HYL STRONG BUY Avg Large

Front Yard Residential (RESI) is our deep value pick among single family rental REITs.
The company own a well-diversified portfolio of affordable housing rentals and trades at
just around half of its NAV. It pays an attractive ~6% dividend yield and we expect double
digit annual returns as the company closes down its excessive discount to NAV.

Note: These opportunities and 33 others are outlined for HYL members in "Our Favorite
Picks For 2019."

Closing Notes
These three REITs have four things in common:

They trade at discounts to their estimated NAV and/or closest peers.

They pay high dividends that are expected to grow in the long run.
They have ample near-term upside potential
There exists clear catalysts for value realization.

Our Portfolio at High Yield Landlord is made of investments like these three. We aim to
buy Real Estate at a discount to fair value to fund our target 8% average yield. It's just
common sense that buying real estate for materially less than what it's worth is a strategy
for superior long term results.

By investing in passive indexes, we believe that REIT investors are set to outperform
Stocks.

However, by being selective, we believe that returns can be improved even further. The
best REIT investors have achieved up to 22% annual returns over the past decades.

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Source

This is what we aim to do at “High Yield Landlord” by specializing in REIT investing. We

are the largest community of Landlords on Seeking Alpha with over 450 members. We
spend 1000s of hours and well over $20,000 per year researching the market for the most
profitable REIT investment opportunities and share the results with you at a tiny fraction of
the cost.

Join Us Today Before Price Increase! Don't let tenants, toilets and trash ruin your life.
Beat the price increase and become a “Passive Landlord” with our 8% yielding diversified
Real Estate Portfolio.

SIGN UP HERE

Disclosure: I am/we are long IRM; JCAP; RESI. 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.

Comments (13)

cemanuel
Agree on REITs, hoping things will be as favorable 3-5 years from now when I roll my 403b over to an IRA. Really like them in tax-advantaged
accounts, as well as BDCs. Bought IRM at $31.72 a couple of weeks ago.

15 May 2019, 11:29 AM

searching value
Thanks for your article. Jernigan capital looks particularly attractive to me; I do have, however, an issue with IRM. I was thinking to buy it, but I am
not certain about its business model. You wrote recently on SKT's model becoming obsolete: I have similar concerns abotu IRM: 5% data centers,
63% still box storage; I am lacking data to understand how successful and how far along they are with adapting to the digital world, and whether
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they will still be needed in a blockchain world - or even before that. They seem to make quite some money with secure shredding and scanning:

fine, but once something is shredded it doesn't need storage anymore, and similar for scanned images - or so it looks to me. So my question
@Jussi Askola : why is SKT bad and IRM good?

15 May 2019, 11:27 AM

Jussi Askola, Marketplace Contributor

Author’s reply » @searching value Thank you for your question.

IRM profits from the transition to digital by offering services such as shredding of documents, scanning, and up-selling its rapidly growing
data center services.

SKT does not have this luxury.

I would add that the paper record business is much stickier than the market seems to be believe. It is not a high-growth sector; but boxes
are actually still on the rise.

All the best, Jussi

15 May 2019, 11:34 AM

farmed out my savings

Mr. Askola, thanks for a good article. I am also waiting for the market to realize that JCAP is a great buy here. Meanwhile, I am loving the 6.6%
payout while I anticipate a substantially higher (REIT) price. Long JCAP.

15 May 2019, 10:47 AM

John Windelborn, Contributor

Jussi, great article. Completely agree on JCAP, but hesitant too consider IRM or RESI a buy. I recently did some digging on RESI and I think it's
going to take a long time to see it blossom into a good company. A little too risky in my opinion.

15 May 2019, 10:33 AM

Jussi Askola, Marketplace Contributor

Author’s reply » Thank you @John Windelborn - I will give it a look :)

What we like in RESI is that there are different activist groups that are pressuring the management to take quick and effective actions to
close the gap between value and price.

Whether they meet their optimistic guidance in 2019 is far from being a certainty, but there is so much meat on this bone that we would
expect outperformance even with a delayed realization of the guidance. The last quarter results were also quite encouraging and led to a
10% bump in a single day.

Thank you agian! Jussi

15 May 2019, 10:43 AM

liquorisquicker
Thanks. Always appreciate an article that brings up a couple of names I haven't followed, and with a good story behind them.

The bad news is that now I have to spend time researching them :)

15 May 2019, 10:33 AM

Jussi Askola, Marketplace Contributor

Author’s reply » @liquorisquicker make yourself a favor and grab a 2-week free trial to High Yield Landlord to facilitate your research
process ;)

To get started on your free trial, please use this link: seekingalpha.com/...

We recently highlighted "Our Favorite Picks of the Moment" in an updated report to our members.

All th b t
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All the best,

Jussi

15 May 2019, 10:38 AM

tradeduck
Hi Jussi, great article... Well written, but I think you missed the elephant in the room ... digital transformation. REIT has underperformed not only
because of interest rate, but the trend of online shopping, digital documents, etc. My point is just that this subject was not covered in the analysis,
but is one of the most important factor.

15 May 2019, 10:32 AM

Jussi Askola, Marketplace Contributor

Author’s reply » Thank you for your comment @tradeduck

You bring up an interesting point and while it is having a negative impact on certain sectors (malls); it is also a strong catalyst for other
REIT sectors such as industrial, cell tower, and data centers...

Regardless of technology, well located real estate will always remain needed in our society. I am not too worried about this trend. There
are many opportunities to profit from it.

All the best, Jussi

15 May 2019, 10:40 AM

usiah
Won't be buying any more IRM only because I already have a "full" position (and glad to have it).

Retired income/dividend-growth investor

15 May 2019, 10:28 AM

JMB1954
Jessi, did this get released to subscribers before the general public? If so I missed it. Thank you! John

15 May 2019, 10:08 AM

Jussi Askola, Marketplace Contributor

Author’s reply » Hi @JMB1954 , thank you for your question! We did not publish this piece to "High Yield Landlord" because it is mostly
general information.

At High Yield Landlord, we focus on actionable, real-time, and concise information. We will post a TRADE ALERT later today, so stay
tuned!

We rarely republish articles to the public. The HYL and Public articles are completely different in most cases.

Jussi

15 May 2019, 10:10 AM

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