Warren Buffett, the greatest investor in history (over 53 years of 20+% CAGR total returns) is famous for his love of contrarian value investing. What’s more some of the man’s biggest winners came in his early days when he proved adept at mastering Benjamin Graham’s (the father of value investing) “cigar butt” style of buying companies at large discounts to book value.
"...if we assume that a very considerable amount of Wall Street activity must inevitably have elements of chance in it, then the sound idea would be to measure these chances as accurately as you can, and play the game in the direction of having the odds on your side." Ben Graham
So, it’s not surprising that plenty of income investors try to “bend it like Buffett” and also try their hand at deep value investing, especially when it comes to REITs, which by law, are a high-yield sector.
But as with all things in finance, there is both art and science to deep value REIT investing, specifically a big difference between a good long-term contrarian value play, and a value/yield trap to be avoided like the plague.
So, let’s take a look at what I consider three yield trap REITs, CBL & Associates (CBL), Washington Prime Group (WPG), and Uniti Group(UNIT)
These are considered by many income lovers, to be either great long-term contrarian investments or value/yield traps to be avoided (depending on who you ask). I’ll show you a simple trick for spotting the critical difference between these two types of REITs, which can hopefully save your portfolio from disaster in the future.
CBL & Associates: Poor Quality Assets That Are Ill-Suited To The Modern Retail Environment
There are two critical points for failure that define a yield/value trap and make it something to avoid, even for value-focused contrarians like myself.
These are the business model and the balance sheet.
CBL’s balance sheet is far from attractive, with stats that should raise red flags, including:
Net debt/EBITDA: 7.3 (sector average 5.8)
Forward net leverage ratio: 7.9 (rising indicates falling cash flow)
Interest coverage ratio: 1.2
S&P Credit Rating: BB- (junk bond status)
But it’s CBL’s business model that’s the biggest problem, resulting in three straight years of declining AFFO/share (27% decline in total with another 17% decline forecast in 2019 per guidance). That declining cash flow, when combined with the highly leveraged balance sheet, explains the terrible dividend track record.
CBL’s first post-Great Recession dividend cut was 26% in Q4 2017, and then, it recently announced a painful 62.5% cut for Q1 2019. Those cuts explain why CBL has delivered -18% CAGR total returns since April 2013, when it hit its all-time high.
Ultimately, the core issue for CBL is that it owns low-quality assets, specifically class C and D malls located in less dense and affluent areas. Remember, in real estate, the three most important things are “location, location, location.”
Well, CBL’s malls are just not well suited to the modern retail environment which is why it’s fully exposed to the “retail apocalypse” that in reality is just normal creative destruction that has always been the hallmark of the retail industry.
Retailers rise and fall, and retail REITs need to be able to replace weak or bankrupt tenants with ones that have what it takes to thrive in the omni-channel dominated world of e-commerce.
CBL’s malls, which have an average sales per square foot of $377, can’t do that, at least not without extremely expensive reinvestment by the REIT. Renovating an anchor store “big box” property can cost up to $20 million, and renovating a property for mix-use can run $50 million.
CBL, with that high debt, and terrible credit rating, suffers from interest rates above its returns on invested capital, and a sky-high cost of equity (67%). That means that management might need to keep cutting the dividend in the future, as it attempts to make its malls relevant enough to survive in their current locations.
Thus, even with a 20% FFO payout ratio (based on mid-range 2019 guidance), CBL’s current 14% yield may not be safe.
Always remember the famous rule of thumb “the safest dividend is the one that’s just been raised” and its corollary “the least safe dividend is the one that’s just been cut”. That’s because companies hate cutting dividends, knowing that it tanks their share prices, and thus only cut if it’s absolutely necessary. That’s especially true of REITs, which is why a dividend cut is a thesis breaker for me personally.
Washington Prime: For Low-Quality Malls, The “Retail Apocalypse” Is Very Real
Washington Prime has yet to cut its dividend, but at a sky-high yield of 17%, the market is forecasting that one is very likely (an assessment I agree with). And given that the REIT’s payout has been frozen since 2015, that points to some major issues for this REIT which was spun out of Simon Property Group (SPG) in 2014 in order for Simon to rid itself of its lowest quality malls.
Those malls have faced the full blast of today’s challenging retail environment which is why Moody’s just downgraded the mall REIT to the equivalent of BBB- with a stable outlook. Now, the good news is that this is still an investment grade rating. The bad news is that WPG faces the same issues as CBL, high redevelopment costs and high leverage (TTM net leverage of 7.1 and interest coverage of 1.2). The REIT’s average borrowing cost is about 4.8%, which is still reasonable. But we can’t forget that the US economic expansion is approaching its 10th birthday (July 1st), which will be the longest in US history.
While a BBB- credit rating may be fine for a REIT at the start of an expansion, economic fundamentals have recently started deteriorating and might be pointing to a recession starting in 2020 or 2021.
During times of financial market fear (including corrections and bear markets), yields on even BBB rated bonds (stronger than what WPG now enjoys) can spike significantly. Moody’s specifically warned that should WPG’s fundamentals deteriorate much further, it might downgrade it to junk bond status, and as you can see above, junk bond yields are much higher than investment grade yields, even in stable economic conditions.
Should WPG face a recession, it will be facing both a potential junk bond downgrade and tighter credit markets in general, meaning refinancing its debt could be both harder and require much higher interest rates.
To give you an idea of how bad things could get, consider this. In December, bond yields spiked so high and fast that not a single US company sold new junk bonds. That was the first such month since 2011. Fortunately, that spike soon abated, but during a recession, it would not.
But what about WPG’s $1.20 2019 FFO/share guidance (which represents a 21% decrease from 2018’s levels, 20% of which is due to higher interest costs from its credit downgrade)? That’s a payout ratio of 83% which should mean the dividend is still sustainable right?
It would mean that except that WPG has exposure to 28 Sears stores that it expects to have to redevelop at a cost of about $325 million in the coming three to five years. What’s more, WPG has 36 JCPenney, 8 Belk, 6 Toys “R” Us stores as well as 11 other ones it classifies as “high risk” and that will probably need to be redeveloped.
But it’s currently only budgeting for basic renovations of those boxes, in order to make them suitable for a new tenant. The REIT isn’t planning major densification/mix-used investments because that would cost about three to five times as much and the REIT just doesn’t have the money to do it.c
At least not with its 2019 payout ratio set so high. Of course, that’s where a dividend cut comes in. Washington Prime is spending $224 million per year on its dividend, and a major cut could free up well over $100 million per year which might be needed should the REIT continue to struggle with its weaker properties and weak retailers going bankrupt.
JCPenney (JCP) is the biggest risk for the REIT because it has 37 stores leased to that dying retailer. What’s been hitting many retail REITs hard lately isn’t just a steady stream of bankruptcies, but the timing of those store closures.
When a major tenant like JCP or Sears goes bust and closes stores all at once, a REIT like WPG must redevelop those stores right away, or else face anchor stores remaining vacant for long stretches which reduces sales for its other tenants.
This is especially true if a company ends up in Ch 7 liquidation rather than Ch 11 bankruptcy (which itself can lead to a lot of store closures). The bottom line is that while WPG is better off than CBL (in terms of less exposure to very low-quality malls), the REIT still faces a big risk of yet another wave of store closures hitting it later in 2019 or 2020.
And that’s assuming we don’t get a recession. If one occurs then WPG (CBL as well) could face a perfect storm of multiple bankruptcies, multi-anchor vacancies and various other tenants closing up shop as well (dark malls).
In other words, cash flow for lower quality mall REITs in a recession is likely to fall off a cliff and result in even more credit rating downgrades across the industry. Precisely at a time when refinancing costs would be soaring due to tightening credit markets that make a dividend cut not just necessary, but possibly even necessitate a full on suspension (dividend goes to zero).
This is why Washington Prime remains a very high-risk stock, and we consider it a yield trap that’s best avoided, especially when economic conditions appear to be deteriorating, making the above scenario more likely.
Uniti Group: Quality, Cash Rich, Wide Moat Assets But One Critical Point Of Failure
Uniti is the opposite case of CBL and Washington Prime, in that its business model is excellent.
That’s because Uniti’s infrastructure assets are mission critical to both modern 4G telecom, high-speed internet, and the coming switch to 5G.
Best of all, most of that revenue is under very long-term leases, with minimal annual maintenance requirement leading to marginal EBITDA yields as high as 100% as it scales ups new customers on its fiber, tower, and small cell nodes.
But it’s the balance sheet and inability to access low-cost capital that’s the critical point of failure that makes a major dividend cut all but inevitable. This is what we just warned readers about, specifically that the Windstream (Windstream) trial loss flips the reward/risk thesis on its head and turns this former spec buy into a “sell”.
As we’ve always warned in every bullish Uniti article, the reason that this was a high-risk/high-reward dividend stock is that a lot had to go right for Uniti’s long-term thesis to hold. That thesis consisted of two critical components, the current dividend remaining intact and management executing on its long-term diversification plan away from Windstream, the distressed regional telecom that accounts for 64% of its proforma revenue but nearly 90% of adjusted EBITDA.
The Uniti’s success sequence looked like this:
1. Windstream wins the court battle with Aurelius: Ch 11 risk goes away (at least until 2023)
2. UNIT price rises and remains above the $20.5 level that management says is necessary to fund growth that’s at least AFFO/share neutral (thus not increasing the risk to the dividend).
3. UNIT issues neutral/accretive equity to fund its upcoming opco/propco deals to hit and surpass 50% diversification target in 2019
4. Moody’s upgrades UNIT’s credit rating (from current CCC+ deep junk equivalent, lowering future borrowing costs and reducing long-term interest rate risk)
5. Lower risk profile = multiple expansion and a higher price, meaning steadily lower cost of equity, accelerating AFFO/share growth
6. Falling payout ratio means UNIT is able to retain more cash flow to organically fund its organic growth capex (scaling its existing assets)
The reason Unit was always a high-risk spec buy is because in order for the bullish thesis to come true, every single one of these steps had to occur, in sequence.
On February 15th, Windstream lost its court battle with Aurelius and now must win on appeal (a multi-month process), convince a very skeptical bond market to lend it the money for the $300+ million judgment to Aurelius, or file for Ch 11 bankruptcy.
Whether or not Uniti’s master lease with Windstream holds up Uniti’s thesis is thoroughly broken, and its cost of equity is sitting at 23.5% as I write this (share price has fallen from $20 to $11).
As we warned in that emergency note on why Uniti is now a sell (even for deep value investors who don’t care about dividends), Uniti’s biggest problem is that the success sequence outlined above has instead flipped to a more likely death spiral sequence that looks like this.
1. On or close to February 26th to February 28th (expected earnings date), Uniti will likely slash dividend by about 50% (freeing up $213 million in annual cash flow to fund its organic growth capex).
2. Share price will plunge further because that’s what usually happens after a major dividend cut.
3. Uniti’s cash cost of equity (AFFO yield, and the only one that matters to investors) will soar even higher (possibly to 30+%).
4. Opco/propco deals become impossible to fund (Uniti just announced the sale of 500 Latin American towers for $100 million to fund its first propco deal, which requires $174 million in cash).
5. Uniti either abandons diversification plan (thus remaining nearly totally dependent on WIN for its AFFO), or it continues with Opco/Propco plan.
6. By funding those deals with massive amounts of hyper dilutive shares that send AFFO/share crashing through the floor.
7. Share price, which is a function of AFFO/share, falls and falls and falls, making every new investment that much more dilutionary and sending share price into a death spiral ala CBL.
It’s always possible that management will figure out a way to avoid this death spiral sequence. But the point is that anyone considering Uniti as an investment, even a deep value “cigar butt” one that Buffett famously made his early fortune on, needs to remember that Uniti’s reward/risk profile is now flipped.
Before the court loss (when most analysts expected Windstream to prevail, including us), the first bullish success sequence was more likely. Now, after the loss, the opposite is true. Morningstar estimates a 50% chance of WIN bankruptcy, which will keep steady pressure on UNIT shares and make the death spiral sequence far more likely than the bullish case.
So, not just should dividend investors avoid Uniti, but even those looking at that 4.2 times AFFO multiple with potentially hungry eyes. How low can a REIT with collapsing AFFO/share see its cash multiple fall? Well, CBL’s is trading for around 1.3. Yes, Uniti’s business model is vastly different and superior to CBL’s. But what ultimately makes Uniti a yield trap to avoid is the risk that Venezuela style hyper share issuances might be coming that sends this stock crashing a lot lower than it sits right now (a new all-time low).
Bottom Line: When Venturing Into The Deep Value REIT Waters, Be Careful To Avoid Yield/Value Traps
The difference between a good deep value REIT and a yield/value trap to avoid comes down to two main things, the business model and balance sheet. A REIT that owns fundamentally well situated and in demand properties/assets will thrive over time, growing both cash flow and dividends for years and decades to come.
But all businesses, including REITs, will face challenges from time to time, which means you need a quality management team that is able to adapt to changing business conditions. A critical component of being able to successfully turnaround a temporarily struggling business is a strong balance sheet. This allows REITs both access to sufficient low-cost capital to fund turnaround efforts, or merely gives them the time they need to right the ship without having to cut the dividend.
If a REIT owns both quality assets and enjoys a strong balance sheet, then it’s more likely to eventually return to steady long-term growth, faster dividend hikes, and deliver market-beating returns.
In contrast, yield traps like CBL, Washington Prime, and Uniti, all have critical points of failure, either tied to their declining business models (CBL and WPG) or can’t access low-cost capital to fund the turnaround effort (i.e. a liquidity trap like UNIT).
And, we can’t forget that we’re very late in the economic cycle, with recently deteriorating economic fundamentals pointing to a possible recession coming in 2020 or 2021. A yield trap REIT that is struggling during good economic times could face financial disaster during a recession when credit markets tighten and the dividend can become the most attractive (or only) option for funding necessary capex or simply ensuring the REIT’s survival.
