Despite the recent rally, a number of REITs (VNQ; IYR) continue to trade at their lowest valuations in 10 years.
- Premiums to NAV have turned into extreme discounts to NAV.
- Rich FFO multiples have turned into low single-digit multiples.
- Yield spreads relative to the 10-year Treasury are pushing all time highs.
But not all REITs are equally opportunistic. Valuation discrepancies are enormous in the REIT sector right now. Some property sectors remain richly valued while others are trading at the lowest they have ever been.
It may seem counter intuitive, but we believe that the best opportunities are currently in the most beaten down sectors of the REIT market, namely retail and hospitality.
The market is pricing these REITs for long-lasting pain. In reality, we believe that this is a severe, but temporary, crisis for retail and hospitality REITs that own high-quality properties.
They suffer greatly right now, but they will survive and ultimately recover to similar-levels as experienced before the crisis. It will be a bumpy ride and we certainly don’t expect overnight results, but if we are even remotely correct, the reward could be very significant in the coming years.
It may seem “too good to be true,” but we expect several of our holdings at High Yield Landlord to double or even triple in the coming years.
In today’s article, we will highlight two such REITs that have the potential to triple in the recovery. The last time they were so cheap, they nearly quadrupled investor’s money in the following two years:
These two REITs are today even cheaper than they were back then. They are feeling the impact of the pandemic right now, but as we explain below, the pain already is starting to ease and we are very bullish at these valuations.
Hersha Hospitality (HT): >200% Upside to Fair Value
Hersha Hospitality (HT) is a small cap hotel REIT with a concentrated portfolio of 48 hotels. But what type of hotel?
We believe that HT owns one of the best, if not the best, portfolio of the entire hotel REIT sector. HT has spent the past five years repositioning its portfolio, selling underperforming assets and reinvesting proceeds into property renovations and new superior assets.
It has left HT with mostly irreplaceable uppercase hotels in strong urban gateway markets such as San Diego, Silicon Valley, Seattle, Manhattan, and Key West to name a few:
Here are a few notable examples from HT’s portfolio:
#1 – Ritz Carlton Coconut Grove – Miami:
#2- The Envoy, Seaport – Boston:
#3 – Ritz Carlton Georgetown – Washington D.C:
#4 – St. Gregory, Dupont Circle – Washington D.C
#5 – Pan Pacific Hotel – Seattle
While not a perfect representation of the entire portfolio, these properties give a rough illustration of the targeted assets. Very clearly, we are talking about an upscale to luxury portfolio:
This is important for us. We much rather own this type of hotels than motels, budget inns, or even midscale hotels in the long run.
- (1) Long-term appreciation: Upscale properties are built in superior locations that enjoy great demand growth and supply constraints. This leads to higher appreciation in the long run as compared to cheaper hotels which do not enjoy the same valuable locations.
- (2) EBITDA Growth: The same applies to cash flow growth. A hotel built in an in-fill location of a growing city will enjoy demand growth but there’s also a moat to protect it from new supply. The budget motels are at greater risk of oversupply with abundant land available in their surroundings for new constructions.
- (3) Airbnb risk: Airbnb and other booking websites are a significant risk for lower quality hotels. However, we believe that four to five-star hotels are better protected and less affected by the growth of Airbnb. They enjoy strong locations, have high pricing power, and offer convenience and services that Airbnb cannot compete with. Moreover, the highly urban markets where HT assets are located are starting to aggressively regulate or even ban Airbnb, which will lead to less supply in the future.
Therefore, we are very confident in the long-term prospects of these hotels. We have little doubt that this type of hotels will remain high demand for a long time, possibly forever.
With that said, they suffer greatly in the short run, and unfortunately for HT, it’s highly leveraged at the worse possible time. This is the main reason why it has dropped so heavily:
Hospitality combined with high leverage is a perfect mix for disaster. No wonder that the market is so pessimistic. But there are good reasons to be optimistic here if you are able to ignore the noise and look at the bigger picture:
Leverage is high at ~8x EBITDA, but it’s not totally unreasonable. They have no maturities until 2021 and the lenders are willing to work with Hersha. They granted them a full covenant holiday for five quarters and even amended their credit facility to add an additional $100 million.
Moreover, the management has taken aggressive measures to cut cost and preserve liquidity. As a result, their current cash burn is low relative to the amount of liquidity that they have.
Finally, things are already improving. Rapidly:
Yet, HT is currently priced at an ~80% discount to NAV. As long as they avoid dilutive equity issuances, we expect the share price to recover to $15-20, which is where it was just a year ago. It would triple investor’s money, just as it in the following years of the great financial crisis.
But don’t take it just from me. The management already owns >10% of the company and they keep buying more. We don’t know any other deep-value REIT with such consistency in insider purchases. It looks like they keep adding more shares every second week when they get their pay check!
They survived 2008-2009 and the management appears confident that they will survive this crisis too. Given the quality of the assets, the current cash burn rate and the amount of liquidity they have, we are confident that they will survive and thrive again.
It’s in a speculative position, but if we are correct, it has the potential to triple in the recovery. We recently increased our position at High Yield Landlord.
Simon Property Group (SPG): >200% Upside to Fair Value
Simon Property Group (SPG) is the largest mall REIT in the world. It also has the best track record and strongest balance sheet, both of which are essential during times of crisis.
The great majority of its cash flow comes from Class A properties located in strong urban markets:
The market hears headlines of retail bankruptcies and translates this into an apocalyptic scenario for mall owners. We agree that SPG and other mall owners will suffer in the near term, but we disagree on the extend of this damage.
Most importantly, the market does not give enough credit for the quality of the properties. It puts all malls in the same basket, but in reality, Class A malls are totally different from Class C and D malls.
From the below chart, you can see that only ~25% of malls are considered Class A. These are not the malls that are dying:
Interestingly, the Class A malls actually benefit from dying malls. The less Class B, C and D malls there is, the less competition the Class A malls will have. When the lower quality properties die, the traffic is consolidated toward the closest Class A malls, which enjoy a lasting competitive advantage in their superior locations. This aspect is ignored by the market.
The economic shutdown may be the tipping point that finally causes many of malls to die. But these won’t be the SPG malls, so it really just means less competition for SPG in the future.
Moreover, it also will accelerate the death of weak retailers that have hurt malls for years. Getting them out leads to some pain today, but it allows SPG to redevelop space and release for better uses. In other words, this could turn out to be a net positive for SPG in the long run.
SPG has an A-rated balance sheet, plenty of liquidity, and a very strong track record. Similarly to HT, the management of SPG is making massive insider purchases at these levels. They bought ~$20 million worth of shares since the beginning of the bear market:
Are they throwing good money after bad? We don’t think so. We believe that these insiders are thinking rationally about the long-term prospects whereas the market is overly emotional and fearful. Insiders are buying shares at an estimated 80% discount to NAV, which is close to the highest discounts to NAV ever for SPG.
As the market narrative shifts from “dying malls” to “mise-use and densification growth from irreplaceable assets,” we expect this discount to disappear and SPG’s shares to triple in value. While you wait, you earn an ~8% dividend yield from an A-rated REIT. Something that‘s truly exceptional.
Bottom Line
SPG and HT are just two examples among many others. At High Yield Landlord, we have positioned our Core Portfolio to maximize recovery gains in the coming years.
Lately, we have been adding more capital to a number of deeply-discounted REITs that we expect to return 50%-200% total returns as things gradually return to normal.
Will all these investments perform as well as expected?
Probably not. But that is why we diversify appropriately. Right now, our Core Portfolio has 24 positions. SPG represents only 4% of it and HT represents even less at just 3%.
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Disclosure: I am/we are long HT; SPG. 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.
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