This research report was produced by The REIT Forum with assistance from Big Dog Investments.
We have quite a few things to cover today including mall REITs, mortgage REITs and preferred shares.
Because we have so many things to cover today, here is a photo of the investments we will be covering in order:
Washington Prime Group
We’ve had some comments on Washington Prime Group (WPG) lately and wanted to explain a couple things.
Our buy and sell ratings
Our current outlook
Shares tanked recently, but we didn't have a buy rating at that point.
Here's an image showing the actual returns for WPG by time period:
It delivered 12.9% during our buy rating (from 4/10/2017 to 7/27/2017).
Since the buy rating ended, it delivered negative 32.9%.
We also had a note on 5/4/2018 telling investors we felt the price was primed to fall:
The lopsided rally has left the risk/reward very heavily skewed. When I first covered Washington Prime Group, the fundamentals were materially stronger than they are today. The difference was primarily the fair value of the physical real estate assets the mall REIT owns. As sales and net operating income have struggled at lower quality malls, the value of the real estate assets decreased significantly. The result is much weaker balance sheets since lower real estate values make it more difficult to finance portfolio.
Meanwhile, we also saw a significant increase in interest rates, so refinancing debts would be more expensive even if the value of the assets had not declined.
Given those two factors, I think WPG’s share price here, just shy of $7 creates a very reasonable exit opportunity for investors who are still holding shares. WPG carries a risk rating of 5 [extremely risky]. This is one of those situations where the facts change and my opinion must also change to reflect the current facts."
Investors who followed our ratings made money on WPG.
Blaming us for WPG tanking after we pulled our buy rating, and especially after we explicitly called for investors to get out, is horribly misrepresenting the truth.
Tanger Factory Outlet Centers
We’ve had some questions lately about our rating on Tanger Factory Outlet Centers (SKT).
In short, we are bullish on SKT when the price is below $23.25 and strongly bullish below $20.50. Most of our content remains on The REIT Forum and takes the vast majority of our time - especially with over 700 subscribers.
We changed our rating on SKT on December 9th in this article (time stamp in the green box):
Returns on SKT
We’ve been bulls on SKT for quite a while and it has been rewarded. It is all too easy for investors to be anchored to a certain starting price. However, investors are buying and selling every day. We want to know if our bullish view was right most of the time.
The following chart demonstrates the number of dollars that would have needed to be invested on any date to reach $10,000 as of this weekend:
We also put together a second version highlighting our purchases and sales:
All of our remaining shares were sold for $24.38 in the first minute of trading on 12/10/2018. This matches the red box in the chart above.
While it may seem that we were perfectly catching the dips, it is important to point out that on 5/15/2018 we had a large unrealized loss. The purchases only look incredible today because we were right on the fundamentals and stuck with it.
The following chart provides the positions that were opening 12/9/2018 in another layout:
These 3 positions come from the last 3 green circles. On the left-hand side of the table, you can see the returns on shares of SKT. On the right-hand side of the table, we have the returns on VNQ over that same time period.
SKT - A New Perspective
Besides SKT putting together a significant rally, we’re also evaluating a long-term change in the expected fundamentals.
The other mall REITs were punished because they have large anchor boxes that will need to be redeveloped.
PREIT (PEI) has already demonstrated how to successfully redevelop those boxes.
Often, the process involves carving it up into several smaller stores.
That process involves a significant amount of cash expenditures from the mall REITs. Investors are finally appreciating SKT (as of 12/9/2018) because SKT won’t be stuck with those expenditures. The downside is that in 2 years, when we expect more of these locations to come online, they will be competing to sign SKT’s tenants. Consequently, we don’t believe SKT is entirely protected from this issue. They suffer less, but they still suffer some.
SKT - The Halo Effect
We expect a growing emphasis to be placed on the “Halo Effect.” The term refers to an increase in online sales to the immediate area following the opening of a retail location. The mall REITs are still working on monetizing this factor effectively, but it already has some appeal in leasing conversations.
The Halo Effect should be most valuable in areas with higher income levels and high population numbers. That is a challenge for SKT as their outlet centers won’t exhibit these traits.
We expect the Halo Effect to assist TCO in driving the strongest average growth in same-center NOI over the next several years.
That alone doesn’t make TCO better than SKT, but these factors must be considered in connection with the share price.
SKT - Short-term Leases
We don’t mind SKT using short-term leases to keep occupancy high. It is a very reasonable strategy. However, given our expectations for a heightened level of new supply to come online (anchor boxes redeveloped for smaller tenants), it becomes riskier. Tenants will have a stronger negotiating position when the other landlords are calling them, encouraging them to fill a former Sears (OTCPK:SHLDQ) or J.C. Penney (JCP).
SKT - Factors that Remain
We still believe SKT is very effectively covering their dividend and should be able to continue doing so for the foreseeable future.
We still believe SKT trades at a discount to the private party value of their real estate. However, private party real estate values for outlet centers may come under pressure. If the private party bid for the assets were stronger, we believe SKT would've been selling more properties to fund buybacks.
SKT - Factors that Changed
We’re lowering our estimate for the sustainable future growth rate of dividends. The prior future growth rate projection was 1% to 4%, we’re lowering it to a range of 1% to 3% based on an expected increase in competition for customers. Based on a weaker future growth rate, we’re lowering our price target by about 8%. The new target price is $23.25.
Taubman Centers - A Replacement for SKT
If investors are looking to invest in the mall REIT sector, we believe that Taubman Centers (TCO) is one of the best choices.
Taubman Centers is one of our larger positions. We consider recent prices on TCO to be very attractive.
When we bought TCO previously, shares were busy plunging from about $50 to about $45. These shares can sell off pretty hard in the market, but their fundamentals remain exceptional. Analysts are failing in their analysis of TCO. Here is a chart from 2017 when we were bullish on TCO:
Here is a recent price drop with another buying opportunity:
We purchased shares when they dipped below $52 and then tripled our position when the price dropped to a few cents over $50.
The bullish case for TCO primarily relies on shares trading at a dramatic discount to the net value of the real estate TCO owns. One challenge to that thesis is the presence of substantial insider ownership. Insiders were able to block Simon Property Group (SPG) from acquiring TCO many years ago. Despite that challenge, the discount to the value of assets is substantial enough to warrant a buy rating.
TCO - Great Assets
TCO’s portfolio is unmatched:
These assets are generally dominant within their trade area and exhibit extremely high sales per square foot.
When the company only has 23 retail assets (plus a handful about joint ventures), the following picture demonstrates the majority of the portfolio.
It’s not like the company can cherry-pick from a hundred locations. TCO’s portfolio is a clear differentiating factor when compared with other mall REITs. They are primarily focused on malls rated “A” and above.
Taubman Centers has the best retail assets in the sector:
The emphasis on high-quality malls leads to much higher sales per square foot and rent per square foot. These metrics help to sustain the company’s NOI and FFO growth. This is through having the best locations, best demographics, strong tenants, and high-quality anchors.
While the company does have a collection of the best retail assets, several of them are in Florida. I would like to see more demographic diversification, but TCO does have fantastic locations. If we are going to be overweight to an individual state, we believe the demographics are favoring Florida.
The strength in sales per square foot is a function of high-quality malls and strong demographics. The median household income and average household income around TCO malls are higher than it is for any peer.
TCO has a very low weighted average rate on their debt. They also have long durations on the debt. Those two factors are very positive.
The long duration remaining on the debt should give TCO more flexibility. However, it is worth recognizing that TCO carries higher leverage compared to their class A peers. This slide did not show the relative leverage. If you study enough REITs, you may notice that the highly leveraged REITs are far less likely to provide a comparison of relative leverage with their peers.
TCO has never reduced their dividend since their IPO in 1992. This includes 2009, when cutting the dividend was the norm for mall REITs.
Orchid Island Capital
We are downgrading our buy rating on Orchid Island Capital (ORC) to a neutral rating. We sent out a public article on 12/18/2018: Buy Orchid Island At 16% Dividend Yield And 17% Discount To Net Asset Value, Short AGNC If You Want To Hedge (subscription to The REIT Forum or Seeking Alpha Pro required).
In the above article, we had a pair trade for ORC and AGNC Investment Corp. (AGNC). After 21 days, we ended the pair trade rating with nearly 10% returns:
The trick with mortgage REITs is to monitor and project book value. Then you can trade around the expected change in the price-to-book ratio. That system allows us to be trading against investors who think you "can't trade in mortgage REITs." We aren't predicting what "will happen" to the book value. We are predicting "what already happened but has not been reported." It is a much better game to play. In the first game (predicting what will happen) you are playing against the best macroeconomists on Earth. In the latter (predicting what already happened) you're playing against investors who don't understand the rules of the game.
I'm here to make money. Why would I want to play the first game? There is plenty of money in the second.
Book value changes in real time with changes in the price of the bonds. Every mortgage REIT already has a book value for 12/31/2018. They haven't reported the 12/31/2018 number, but it already happened.
Rather than trying to predict what will happen from now through 3/31/2019, we are making predictions about how the movements that have already occurred have impacted the value so far.
Capstead Mortgage Corporation
Capstead Mortgage Corporation (CMO) holds pretty much nothing except for ARMs (adjustable-rate mortgages). Due to the flattening of the yield curve, they have slashed their dividend repeatedly. The Q4 earnings release will most likely show a dreadfully low figure for earnings. When the curve flattens, that is exceptionally bad for CMO’s earnings.
If we initiate a position in CMO, we would want enough dry powder to be able to double down at least once.
However, CMO trades an estimated ratio of .77. That is exceptionally low and CMO’s losses should actually be smaller than many of their peers. There is one large positive factor to consider though. The rate on CMO’s mortgages take time to reset, but part of their cost of funds is resetting very frequently. Despite the hedging, when short-term rates (such as 1-month to 3-month LIBOR) are rising quickly, it drives their cost of funds higher. If the Federal Reserve is actually done hiking rates for the next 12 months, we would expect CMO’s cost of funds to level out during 2019 while the yield on assets could still climb moderately.
The Major Risk: The biggest risk, perhaps the only risk worthy of consideration at this discount, is the risk of inversion. If the yield curve inverts, we would expect the net interest income to plunge even further. Based on higher projections for prepayments on ARMs, the book value would decrease at the same time.
Upside 1: If the curve steepens through higher long-term rates, prepayments would plunge. A large increase in net interest income due to lower amortization.
Upside 2: If the curve steepens through lower short-term rates, prepayments could decrease slightly while the cost of funds would fall (in 2019, probably Q2 to Q4). A large increase in net interest income due to lower amortization and lower cost of funds.
Upside 3: The price-to-book could increase naturally due to it being so far outside the normal levels. A 23% discount (which is the same as a .77 ratio) is very rare for CMO. One potential catalyst is insider buying. After the last dreadful earnings release, insider buying gave us a catalyst to get shares moving higher again.
PEI and PEI-D
For the common stock of PREIT (PEI), we had a public article come out at the end of December: Buy PEI: Even The Bears Are Giving It 32% Upside (Subscription to The REIT Forum or Seeking Alpha Pro needed to view this article).
Even though the price has rallied significantly since then, we are still bullish.
We had an interesting opportunity in PEI-D. Near the end of 2018, fundamental valuations completely broke down. We witnessed massive failures in market pricing. The deviations in prices are absurd, which is the best possible scenario for entering new positions.
The market became terrified of a recession. It looked like early 2016 or early 2018. Stock values were down, economic indicators were down, but they were telling us things we should’ve already known. The economy is still performing well. Unemployment is still low. However, the prospect of slower growth is terrifying to Wall Street.
To account for the price swings and finding relative values, we modified our price targets in two ways. We reduced targets based on the risk rating. Higher risk shares saw a larger reduction. We also put in a small reduction on preferred shares that are FTF (fixed-to-floating).
Because of market fear, we were able to pick up shares of PEI-D for $15.13 on 12/26/2018.
We are still bullish on preferred shares from PEI, but the current prices aren’t near as attractive. However, we still believe there is a lot of room for upside.
We also bought preferred shares from Two Harbors (TWO) during the panic.
TWO-E is a great preferred share because of a combination of their risk rating, high stripped yield, and discount to call value. While there is no more call protection on the calendar, the discount to the call value of $25 is a form of call protection.
We had a real-time alert go out to subscribers of The REIT Forum after prices had plunged:
We purchased shares of TWO-E on 12/21/2018 for $22.30 and have seen a total return of 6.18% as of 1/9/2019.
Bullish: SKT, CMO, TCO, PEI, PEI-D, TWO-E
Neutral: WPG, ORC