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Investing, Stocks  | January 7, 2019

This research report was produced by The REIT Forum with assistance from Big Dog Investments.

We have 3 buy ratings to bring you today.

We witnessed a massive decline heading into Christmas followed by a decent rally over the next few days. The decline and subsequent rally hit most sectors, though it clearly hasn’t hit all stocks equally.

The following chart, from The REIT Forum’s common share spreadsheet, shows current prices relative to our targets:

Source: The REIT Forum

When we provide these updates, it is important for investors to understand that our ratings and investment choices depend on “relative valuations”. We want to consider whether a stock looks cheap or expensive relative to peers and in isolation.

We will be going over 3 of the companies in the chart above.

Equity Lifestyle

Equity Lifestyle (ELS) is the first of the manufactured housing park REITs. They tend to trade at higher FFO multiples than any other type of housing REIT. Why do they get such a premium? Beyond ELS having an impeccable balance sheet, the manufactured housing parks exhibit very strong growth in same-property NOI.

They’ve been able to raise rents at a steady rate, performed very well on occupancy, and restrictions on building manufactured housing parks have insulated them from competition. ELS is slightly above our target, but liquidity can be weaker than you might expect for a REIT with an $8.6 billion market cap on common equity. That means investors should occasionally toss in low-ball limit-buy orders since the intra-day price can look much more volatile than the long-term chart would suggest.

MH Park REITs have dominated:

Sun Communities

Sun Communities (SUI) has enjoyed rapid growth as well and is currently the more attractively priced REIT (by 1.6%, so it’s a small gap). Much like ELS, they’ve done an incredible job of growing their NOI.

While their same community NOI growth was barely positive in 2009, it was still positive. That put them well ahead of most other sectors.

Some investors won’t like SUI because their dividend yield is only 2.82%. However, their payout ratio of .58 is quite low. It is slightly above the .53 ratio for Equity Lifestyle, but it is very low for the REIT industry. When investors say they only care about the dividend yield, they are ignoring the growth created by prudent management investing retained cash. The MH park REITs have very attractive opportunities for reinvesting that cash:

Source: SUI

Despite new developments being severely restricted by zoning authorities, ELS and SUI have been successful in getting approval for expansion within their communities. The unlevered IRR (internal rate of return) on these investments is exceptional. The only reason this is possible is that they already own the land and only need to create new pads. The renter is paying for the physical structure, so SUI and ELS have a smaller investment.


American Homes 4 Rent (AMH) is a single-family housing REIT. They are replacing the typical rental property owner who would own 1 to 4 units. AMH benefits from dramatically better economies of scale. They maintain an investment grade balance sheet and they reinvest the vast majority of their cash flows. Consequently, many investors who are used to single-family rentals may initially be put off by the 1% dividend yield. It’s about a .17 payout ratio, which is the lowest among any REIT we cover.

However, the single-family REIT sector, mostly AMH and Invitation Homes (INVH), took a much larger hit than most REITs over the last several months. The issue wasn’t their dividend yield. The issue was a significant weakening in expectations for earnings growth. Growth in FFO per share is driven by growth in “Core NOI”. Specifically, analysts want to see growth in “Core NOI after Capital Expenditures”:

A growth rate of 2.5% to 3.0% isn’t “bad”, but it isn’t what analysts were hoping to see. In an update several months prior, AMH was guiding for 3% to 4% growth on that line.

Source: AMH

Analysts tend to extrapolate trends far too much. Consequently, they were too bullish on single-family housing REITs in 2017 and now they are too bearish. That’s what happens when you simply plug in a new growth rate to a spreadsheet and hope the computer can handle the ratings.

Importance of Relative Valuations

The lesson for investors who are new to the concept of “relative valuation” is to remember the importance of considering each investment against other comparable stocks. When determining whether a stock is a good investment, it helps a great deal to have a solid knowledge base on several of their peers.

This is a flaw for many popular analysts. By covering an area that is too wide, they don’t have sufficient resources to thoroughly dive into each stock. Even a great initial report lacks the follow up to stay on top of the subsector. Perhaps just as dangerously, many investors coach their friends to diversify while doing all of their own research. Diversification is great. To get diversification, there are three options.

  1. Get an analyst for every sector (can be too expensive for some investors).

  2. Pick individual sectors to study and analysts who cover them, use ETFs for the rest.

  3. Drive yourself crazy trying to stay up to date on several stocks in different sectors without any professional assistance.

Many investors coach their friends to use option 3, which is generally the worst choice available. It is a major reason so many investors underperform the stock market by a staggering amount:

While REIT indexes returned 9.1% annualized and the S&P 500 returned 7.2% annualized, the average investor achieved only 2.6%.

At The REIT Forum, we have a limited scope of coverage. Some investors prefer to get a service that is “more diversified”. Effectively, they want to buy research from an analyst who is picking option 3. Does that seem like a great choice?

To close things, we’d like to wrap up 2018 by showing just how effective relative valuations can be. There are 2 main things investors should take into account:

  1. If the stock looks cheap relative to peers but expensive in isolation, then the sector is probably overvalued. We may want to underweight the sector.

  2. If the stock looks expensive relative to peers but cheap in isolation, then it would be better to inspect the peers and buy one of them.

We’ve found relative valuations matter a great deal in predicting returns. We wrote a Rapidfire update for subscribers on 6/27/2018.

In that article, we wrote:

The top choices for apartment REITs currently are AvalonBay (AVB), Equity Residential (EQR), Essex (ESS), and AIMCO (AIV). While AIV and EQR are just under their target prices, AVB and ESS are only a hair above them.

We were also bullish on SUI and ELS. That gave us 6 choices for investors. Their performance (dividends + change in price) is shown below:

We can’t complain about the results for any of those REITs. Each delivered a solid price performance to go along with the dividends paid.

In the same update, we labeled Camden (CPT), Mid-America Apartment (MAA), UDR (UDR), INVH, and AMH as the less appealing 5 choices.

Among our 5 choices that we felt were less appealing on that day, UDR was the one we had downgraded too soon. Regardless, the focus on relative valuation (and a bit of luck) allowed the 6 picks to each land in the top 7. That’s better than we expect to do.

Alternatively, investors could look at the returns since our update on October 8th. In that update, we were down to 3 buy ratings, AIV, SUI, and ELS. Those 3 performed reasonably given the difficulty in the sector:

In the article, we also discussed UMH Properties (UMH) which we considered a dramatically inferior manufactured housing park REIT. Their price may properly reflect those flaws now. We rarely cover UMH because of excessive leverage and management’s other choices. Our October 8th update provides some great clarity regarding the flaws in UMH.

Including UMH, these are the other 9 housing REITs discussed in that article:

We ended up with 3 buy ratings for that article and all 3 landed within the top 4 (out of 12) for performance since then.

The weakness to using relative valuations is that investors who are not willing to sell shares at any point will only benefit going in and during dividend reinvestment. For dividend reinvestment it is ideal to take dividends in cash and then use them to buy shares in the least expensive REIT, so long as commissions are immaterial. The benefits of relative valuation are focused on picking the right stock within a sector at any given time. If there is a long term fundamental shift, investors would want to reallocate accordingly.

These techniques also work best when there are multiple highly comparable investments. An investor or analyst couldn't use these techniques effectively to pick between a tobacco company and a gold mining company. It absolutely relies on having multiple companies that are extremely comparable. This is a major reason we focus on REITs. They are ideal candidate for this kind of valuation. On the other hand, companies with huge R&D spending are less likely to be this comparable even if they were in the same industry.

Perhaps the most noteworthy weakness is that many people claim to be using relative valuations without actually doing it. If the analysis ends with the dividend yield or FFO multiple, rather than starting there, it is akin to calling one situp a workout. Sadly, many investors who are knew to REITs simply declare they want the biggest dividend yield. Those investors, who believe they have earned superior returns by figuring out which number (dividend yield) is bigger, often speak loudly about how horribly their choices have performed and how it isn't their fault but rather management's fault. They are wrong, but they are also very loud.

We have buy ratings on AMH, ELS, and SUI. We aren't fooled by their low dividend yield. We can see the management is effectively reinvesting cash flows to drive faster growth rather than paying it out in dividends today.

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