Looking for Deals in Rundown REITs

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Assuming we're at least near the end of this tightening campaign from the Fed, history has shown the REITs outperform almost always in the aftermath of such a campaign.

Hello and welcome to the Barron Streetwise Podcast. I'm Jack Howe, and the voice you just heard is Richard Anderson. He heads the US REIT coverage at Wedbush. REIT as in real estate investment trust, things that hold property and collect rents and pay it out to shareholders as dividends. The group has performed poorly this year, but Richard and Wedbush argue that it's due for a recovery next year. We'll hear the details and we'll look at what to expect from third quarter earnings reporting season. Listening in is our audio producer Meta. Hi Meta.

Hi Jack.

You know what I mean when I say earnings reporting season, right? Sure. They all just kind of, they cluster together. They come flying in these reports. One minute everybody's talking about macro stuff and geopolitical stuff and the next minute saw company earnings and the focus shifts. It's a little weird calling this third quarter earnings season because it's not third quarter results for all of the companies. Some companies have fiscal years that start at different times. It might start in July and run through June, but it's the reports that we would like to count towards the third calendar quarter so that we can see how the stock market as a whole is doing. Does that make sense, Meta?

It does.

I know what you're thinking. You're thinking, Jack, could you explain to me how we can tell that earnings reporting season has started? Could you walk us through the history of it? And, um, you know, maybe some overly long details with not such a great payoff. You got it coming right up. It used to be that earnings season would start off with Alcoa, which is an aluminum company. And the reason it started with Alcoa was because that was the first one in this sort of cluster of companies that would report in the Dow Jones Industrial Average of 30 companies. But some things changed. 2013, there was a big aluminum slump and Alcoa got kicked out of the Dow. And then a few years later, it spun off commodity smelting and it named that company Alcoa. And then it gave itself a new fancy name to denote that it was doing engineered products. I can't remember that fancy name at the moment. It started with an A, but anyhow, it doesn't matter because this year that fancier named company got bought out by private equity. So the Alcoa that we all knew, it's not around anymore. There's this sort of smelting stub that's a different company. And, you know, anyhow, you can't really say that that kicks off earnings season, right? So you needed a new kicker offer for earnings season. And over the years, It just became sort of agreed upon that it would be big banks. And when I say agreed upon, I mean at least 3 people said it on CNBC, so you know it's for real. And 3 big banks— Wells Fargo, JPMorgan, and Citigroup— report earnings on Friday, October 13th. And that will mark the start of third quarter earnings season for S&P 500 companies. Was that story everything I promised? And more. And so let me give you some details on what to expect from earnings reports coming up. First of all, Emetta, please prepare the celebratory party horn for this announcement. S&P 500 companies will on the whole report earnings growth of— that's too soon— of zero. Hang on, it's better than it sounds. For the past 3 straight quarters, S&P earnings have fallen year over year. So if we get to zero, that's a step in the right direction. And there's reason to believe that things could look even better than zero with some, you know, some adjustments, a little bit of excuse making, some squishing and squashing here and there. For example, the oil price is up since June, but on average during the third quarter, it was about 10% lower than a year ago. And that means that energy sector earnings will stink. They're estimated to come in 38% lower than a year ago. That's the worst of any sector by far.. And that holds down earnings growth for the overall index. If you take out energy, index earnings are expected to grow 5%. You're starting to cheer up already, Meta, I can tell. Let me keep going. Let's leave energy in. The earnings number for the S&P 500, that's cap weighted, just like the index. If we were to look at the typical company's experience, if we were to take the median earnings growth rate, in other words, the middle company, That's a positive 2% estimate. I'm not winning you over, but this next one is definitely going to do it. Let's remember that that 0% forecast, that's a consensus estimate, right? And those are usually too low. Analysts and companies go through this elaborate ritual heading up to earnings season where there's some suggestions, some coyness. They do different things to set up success in a column recently in Barron's, I compared it to peacocks mating, except the preening usually happens at the end. If you look at the past 10 years, company earnings have surprised to the upside nearly 3/4 of the time, and the average amount has been 6%. Exactly, peacocks. So even though the estimate for the recently ended third quarter is zero, the actual earnings growth number that we get could be solidly positive, but by how much? I don't know. Goldman Sachs says that upside surprises this time around are likely to be smaller. And one of the reasons— and see if you can follow this logic because I have a hard time following it— they say that the earnings estimate revisions that we've had, the changes to the estimates since the end of June, there haven't been many changes this time around. Usually those estimates fall. And when they fell in past quarters, Goldman takes that to mean that analysts were sufficiently pessimistic. But this time around, because the estimate has been stable, they say they're setting a higher bar. And so comparisons might be more difficult. We'll still get an upside surprise, but it might be smaller than usual. Now I think I've confused myself. Let's put it this way. B of A Securities estimates that actual third quarter earnings growth will be positive 4%. Pausing now for hoorays. And as I hear myself say that out loud, it's not that exciting, but it's on the path to better things. Perhaps the consensus estimate for the fourth quarter is positive 8% growth for the full year. Goldman says that fourth quarter result will be enough to pull overall earnings growth for the year up to positive 1%. B of A says 2%. For next year, Goldman is looking for 5% earnings growth. B of A says 6%. So maybe, just maybe, this third quarter reporting season will represent the turnaround where we go from slumping earnings back to growth. One more thing, even though earnings season kicks off with banks, there are these companies called early reporters because, you know, they come before the banks, 'cause they have weird fiscal years, but they're important. And you can look at those companies and B of A finds a 70% correlation to what they do in terms of surprises to what all companies will do. And that's good because 3/4 of those companies, it's 21 of them so far, 3/4 of the 21 have reported upside surprises. And Meta, guess what business the company with the biggest upside surprise of all is in? Cars? You got it. French fries. It's called Lamb Weston Holdings. Did you know there's a company out there that specializes in just fries? Straight fries, crinkly fries, curly fries, waffle fries. They also do tater tots. I think it says something that a company that just does fries is large enough to be in the S&P 500 to begin with. But earlier this month, Lamb Weston reported a 50% upside surprise on earnings, sending its shares up 8%. There have also been positive surprises for Nike and FedEx. I've heard of those. The fastest earnings-growing sector of the quarter is likely to be communications, mostly because communications these days includes Meta Platform, the owner of Facebook and Instagram. Meta Platforms has got new religion on cost-cutting, so its earnings are expected to double this quarter, pulling communications earnings overall up 31%. The number 2 sector should be consumer discretionary. With Amazon, that sector is expected to grow earnings by 22%. Without Amazon, 14%. By the way, there have been earnings missers too. FactSet Research Systems has compiled a list of them, and the biggest earnings misser so far is FactSet Research Systems. Came up 16% short. That's not awkward, right?

Not at all.

I'm going to tell you one last thing, and this comes courtesy of B of A. They did this prediction. It's one thing to talk about companies that have missed earnings, have beaten on earnings, but it would be better, of course, to know the ones that are going to do that. And B of A has attempted to do just that. It ran a screen for companies based on a couple of things. One, the types of surprises they've had in the past. There's research that shows that these things tend to be a little sticky. Companies that, that report surprises in one direction in a given quarter are likely to do the same in future quarters. So they screen for that. They also screen for where B of A's own analysts disagree from the rest of Wall Street on the assumption that they're doing a better job than everyone else.

Okay.

And then they take that list and they cross-reference it with ownership data from mutual funds to show which stocks are over-owned or under-owned. All right, so after that big long process, the candidates they say for upside surprises that also happen to be under-owned by mutual funds— the implication there being there's more buying to be done— those names are Arch Capital Group, ACGL, PulteGroup, PHM, Home Depot, HD, Cintas, CTAS, and Western Digital, WDC. Now, the candidates for negative earnings surprises according to B of A that are also over-owned by mutual funds, those are Charles Schwab, SCHW, Robert Half, RHI, and Equifax, EFX. Equifax? Equifax. Where do you come down, Meta?

Equifax.

I have a lot of trouble pronouncing things, I'm realizing, for a guy who does a podcast. We're going to have to work on that. Matt, time for a break. I've given people a lot to get excited about on the subject of earnings. I don't want to overdo it. I don't want to, I don't want to get people over jazzed. We want to save something for REITs. Break here? Break 5 minutes ago? I think break here is fine.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, We analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.

Welcome back. REITs have mostly stunk. US ones, last I checked, had fallen 7% this year, not counting dividends. The S&P 500 was up 11%. So you combine those and it's 18% underperformance for REITs versus the index. For people who don't know, a REIT is, how shall I say, it's a 60-something-year-old structure, business structure, where you can buy property and collect rents as income and pass the bulk of that income on to shareholders as dividends, thereby escaping corporate tax. It's this kind of pass-through for income to investors. And the idea is to give Joe and Sally Saver a way to get in on investing in big commercial real estate.. And there are all different kinds of REITs out there that focus on medical offices and parking garages and storage facilities and data centers and on and on. Investors used to look to these mostly for income. Nowadays it's a mix of income and growth. Wedbush, the investment bank, recently initiated coverage on US REITs, meaning they have fresh opinions on the entire group and which ones they like and which ones they don't. And I thought that was a good opportunity to check in on whether REITs look poised to rebound. So I checked in with the head of US REIT coverage over at Wedbush, Richard Anderson. Let's play that conversation. REITs have not done well, particularly lately, and sounds like you see some value here. You think it's a good time to get into REITs in general. Do I have that right?

You have that right. Perhaps not at this moment, maybe more at the turn of the calendar, but what we've seen is fairly dramatic REIT underperformance over the past, call it going on 2 years. As of the writing of that report, 2,200 basis points of underperformance that has created a very nice valuation perspective. Nice meaning cheap. The REITs as a group trade at a 15% discount to net asset value. And a 4-turn discount to what they would normally trade at from a cash flow multiple perspective. But valuation alone is not a call. Valuation requires a catalyst to tether to, for it to have legs. And that catalyst we think could be a wave of consolidation in commercial real estate generally and involving the US REITs specifically that we think will bring positive attention to the space. Over the course of 2024 and beyond.

I'm going to translate a little. I speak fluent analyst, but for the people who might listen to this on a podcast who don't, I'm going to just translate and say, when you say 2,200 basis points, you mean it's underperformed what the stock market by 22 percentage points. Correct. And when you say it's 4 turns cheaper than normal, you mean if it has been trading at, I don't know, 19 times Funds from operation, now it's 15 times or something like that.

Have I got that right? That's right. The real numbers are 21 times and currently 17 times. Got it. And perhaps now 100 basis points lower than that given what we've seen, you know, post non-government shutdown, post no speaker in the House. You know, a lot of disruption has happened since we did this report, but the rule still applies.

And why do you say the turn of the calendar?

What's the significance there? I think people have written off the REITs for the remainder of this year. I think taking a flyer and being a hero late in the year and disrupting one's books that get published at the end of the year is probably not my expectation, just being realistic there. But also, we still don't have absolute clarity on where the interest rate environment's going to land. We still don't have absolute clarity on the economy, but I think that that comes during 2024. And then what happens? Well, we live in a higher interest rate environment, and so everyone will have to adjust to that. But the REITs are a 10% owner of the entirety of the commercial real estate industry. The REITs are 5 times levered. The overall industry is at least double that, if not more. So who's more equipped to exist in a higher interest rate environment and who is just struggling to get by? I would say the, the latter is the private market of ownership of commercial real estate and the former are the US REITs that have the balance sheets, the cream of the crop in terms of platform value and all the rest. So that's the thesis, but it may take into 2024 to come to fruition.

Because those institutional buyers who might come around to REITs, they might not do that until early next year. But Joe and Sally Saver who are out there interested in some income, they can do their shopping now and line up some REITs they're interested in and maybe, you know, consider a purchase later in the year.

You could do your shopping now with the benefit of the valuation perspective that I mentioned. This is not a situation where the REITs are expensive, so you really have to take on some valuation risk. That's not the case at all. And by the way, assuming we're at least near the end of this tightening campaign from the Fed, history has shown the REITs outperform almost always in the aftermath of such campaign. So precedence is on our side. Every situation, every cycle is different. I acknowledge that, but I'd rather that precedence than the alternative.

And how do you size up REITs? And I realize that this is a very diverse group, and so it might, might be different for all different sorts of REITs, but for people out there who've never done that, what kinds of attributes are most important when you're looking at REITs?

Supply and demand is number one across the board, meaning if there's a wave of new supply coming in the form of construction, That's bad if you're long the space. And so what we're seeing now is some pockets of supply in particular in multifamily in the Sunbelt and in the industrial space, which is just a fantastic asset class that merchant builders have, have chased. But the new reality of financing those developments will likely reduce new starts over the coming few years. And that's good for the REITs that are already long the space. They don't need that new competition from development. So supply and demand is number one. But you're right, I cover a sector that's made up of 18 different property sectors that happen to share the same tax code. So every conversation is different, whether I'm talking about industrial REITs and them being the beneficiaries of e-commerce and all the demand that's coming their way from that, Or I'm talking about multifamily and the benefits that they receive from higher mortgage rates and student loans now having to be repaid. Their renters are going to have a more difficult time leaving to go and buy a home. And then malls and shopping centers. And of course, we haven't even spoken about office yet, but everything has a different dynamic to it. But the overriding theme is supply and demand.

When you say industrial, there's a lot of warehouse space in that group, right? A lot of distribution centers. Yeah.

That's what I'm talking about.

Can you give me some sort of, you know, maybe not a full ranking, but what are some groups that are your favorites right now and what are some ones that you're more cautious on?

Yes, sure. So I mentioned multifamily. There's a lot of good things stacking up for that group. This is apartments for rent. And there the main negative forces of demand center around Individuals or small fam— young families going to buy a home, and that's become increasingly more expensive as we all know. The shortage of housing generally is good, again, if you're long the space. So we like multifamily and the underlying dynamics there. Related to that is senior housing. So this is an asset class that got pummeled during the pandemic, as you can imagine, caring for the elderly people and occupancies declined from running at a normal pace of 88% down to well in the mid-70s, if not lower. So they're in recovery mode now. And so senior housing is another sort of asset class that we like and has flourished in the post-pandemic era. Then there's a smaller asset class called gaming REITs. They own casinos primarily. And when we went into this pandemic or any recession, you would think are people really going to gamble during a recession or God forbid during a pandemic? And the answer is yes. The gambling sort of DNA treats gambling like bread and water. And so that litmus test was passed for the gaming REITs and they continue to do well. Now it's only made up of two companies. VICI is a very large $50 billion enterprise and GLPI Gaming and Leisure Properties is a smaller entity but growing off a smaller base. So we think that there's good stuff going on there as well.

I'm trying to get my head around a gaming REIT. I mean, if you don't own the casino, what do you— what exactly? I guess you're just running the games or I'm not sure what you're doing. That's a pretty asset-light operation if you're a casino who doesn't own its own casino.

Very good point. Asset light is a real concept in my space. In the case of the gaming REITs, They own the physical real estate asset. So they own the MGM Grand or Mandalay Bay, or, you know, you go down online or someplace in Biloxi, Mississippi, and the operators of those gaming facilities pay a rent to the REITs. And what we focus on is rent coverage. What's the credit of the operator and how able are they to pay their rent? And what we learned is very well. It's been a fairly clean story despite everything that's been going on around us.

Okay, so those are some groups that you like. Are there some ones that you're more cautious on right now?

I mean, the obvious one is office. So conventional office is still digging itself out of the narrative of work from home, hybrid office. And as leases expire in the office space, we just don't know what tenants are going to do when it comes to the space they're using. As a hypothetical example, if Company XYZ is leasing 50,000 square feet of space and they're fighting like heck to get their employees to come back to the office, but it's a losing battle, they might just throw in the towel and say, well, we don't need 50, we can live with 25,000 square feet. And that obviously is a bad event for from the REIT's perspective. So it's lower demand. And so I think that that is all still working itself out. And, and so we're cautious on conventional office, but there's areas of office we like where the physical asset plays an important role in the underlying business, namely medical office or life science office where drug research is performed. So you have to kind of dig into the weeds a little bit in office to get comfortable.

And I, I have to believe that's an example of where you can probably find some mighty tempting valuations in office REITs, but it's one where there's more to that story than you might see on the surface that the bottom could fall out on some of those cash flows. Is that the idea?

We've never been the type to say, oh, look at that double-digit dividend yield, let's go and buy that stock. That's normally a deal with the devil. Now there are some very good high-quality office REITs, and so I don't want to paint overly broad of a brush. BXP Incorporated is a very well-run company, employs the best of the best in the space, and owns some of the highest quality buildings in the country. But they too are experiencing the situation. In fact, little side story, BXP doesn't use the word office anymore. They use the word workspace.

They don't want to associate themselves with the term I guess it, it works because I've been working in offices long enough to see the transition from when people used to have actual offices to where they're just now sort of jumbled together in a big room with some, you know, cubicles or what have you.

So I guess, I guess workspace works. It's evolutionary, and it resembles in many ways like the mall business did 15 years ago or 20 years ago when e-commerce came into town, and they suddenly had to adjust their business model for the opportunity for consumers to just go on Amazon and buy something at 10 o'clock at night and have it on their doorstep the next day. And so the malls have evolved in that environment. I think likewise, the office REITs will have to— office business will have to evolve in this new paradigm of work.

Before I let you go, could I trouble you for a few of your favorite REITs right now to, to give folks some examples?

Sure. I mentioned liking multifamily. UDR, ticker UDR, formerly called United Dominion, but that was a long time ago. One of the best-run companies in the country, no matter what asset class. Ahead of the game in terms of the deployment of technology to run their facilities. They have less and less reliance on people, which is good because wage pressure is a real thing in this space. So UDR is among our favorites. Alexandria, ticker ARE, is an office REIT, despite what I said, but a life science office REIT. Over 90% of their business caters to the biopharma industry. That stock has been decimated too because the biotech world is under microscope and has been over the past 2+ years. And there's some issues about oversupply in life science and there's a lot of conversation around that sector, but the stock is extraordinarily cheap. And to give it some context, the conventional office market is about 80% occupied on average across the United States. Alexandria is 95% occupied.

It looks like the dividend yields on both of those are hovering around the 5% area, a touch under for UDR and a touch over for Alexandria.

Yeah, so that's a good signal to me. Now what that means to me is they're retaining as much cash flow as possible to deploy into their business. And so the best REITs, you know, a lot of talk about REITs and how they tether themselves to the 10-year Treasury, and if interest rates are going up, that's bad. But the REITs have become less and less correlate or negatively correlated with rising interest rates. And this is one example. REITs that are doing a good job are investing within and retaining as much capital, paying out what they have to, to remain a REIT, but just enough. And so that they can use the money to spend elsewhere. And then the third one, I mentioned gaming. Everyone likes VICI, V-I-C-I, and we do too.. But our— we think the better name in the space is Gaming and Leisure Properties, GLPI, outperform-rated. This is a company that does not invest on the Las Vegas Strip. They invest only in the regions of the United States, so Indiana, Mississippi, you name it, outlier areas where there's a lot of dedicated gamblers that go there as a matter of their lifestyle, and it's shown to be a very sticky sort of demand profile for that regional business. And so they have lined themselves with several operators and have created a pipeline of future growth off of a relatively smaller size. So to put in context, Veatch is about a $45 billion enterprise. GLPI is about an $18 billion enterprise. And so we see more growth potential from GLPI. Both are great companies.

GLPI we like better. Hey Richard, one last question. For someone out there who maybe doesn't have the stomach for buying an individual stock, but they're eyeing a REIT index fund, like a cheap fund or something like that, is that a good idea? Is that the same sort of thing where maybe later this year a REIT index might look attractive?

How well does indexing work for REITs? Indexing works wonderfully. It takes the onus off of you and puts it on professional money managers. There are fantastic money managers that are dedicated to this space that absolutely do the work for you in a very effective way.

Thank you, Richard. We'll see if that rebound that Wedbush is looking for plays out next year. For investors who don't buy individual stocks but want some more REIT exposure, there are index ETFs, for example, Vanguard Real Estate ETF, the ticker there is VNQ, and Charles Schwab US REIT ETF, that's SCHH. And I think that's it, right, Meta? Yeah, I think so. We should thank Richard. Who else should we thank? We should thank the peacocks from earlier. And thank you, Happy Horn and Sad Horn. And thank all of you for listening. Metta Lutzoff is our producer. You can subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen. If you listen on Apple and you're in that cross-section of people who sometimes write reviews for things online, but you're not perpetually cranky or weird, go ahead and write us a review.

See you next week. Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you.

Morningstar, where data speaks.