Diversified REITs: Where to Hide?

by Will Ashworth | August 14, 2013 11:50 am

We’re about halfway through the third quarter, and REITs of all stripes are taking it on the chin thanks to rising interest rates.

The First Trust S&P REIT Index Fund (FRI[1]) tracks the investable U.S. real estate investment trust market. It’s flat through the first six weeks of the quarter compared to 5.4% for the SPDR S&P 500 (SPY[2]). Diversified REITs—those investing in two or more types of real estate—have been hit especially hard. According to FINVIZ.com[3], all 15 diversified REITs with market caps of $2 billion or more are down for the quarter.

With a higher cost of capital, REITs have less cash to acquire new properties and lower yields for investors. Some are calling the slowdown the beginning of a secular change where REITs will go out of favor for a significant period of time. If so, it appears there’s very few places to invest going forward.

But “very few places” is much different than “none.” A couple REITs might still be worth a look:

Starwood Property Trust

Anything that Barry Sternlicht operates is worth considering. Until the middle of 2012, Starwood Property Trust (STWD[4]) was primarily an externally managed commercial real estate lender and investor. Then, two things happened:

  1. First, it began acquiring single-family homes in Florida and other residential markets. To date, it has acquired almost 4,000 homes as well as non-performing residential mortgages totaling $450 million.
  2. Then in April of this year, it acquired Lennar’s (LEN[5]) former commercial real estate business, LNR Property LLC, from a consortium of investors for $731 million.

In less than two years, it has gone from one reportable segment to three.

The acquisition of LNR Property LLC gives STWD a strong loan origination and servicing business that will immediately provide the REIT with greater scale in the U.S. and Europe. Through the first six months of 2013, on a pro forma basis, Starwood’s revenues increased 14% to $304 million with net earnings improving by 34% year-over-year to $202 million. LNR’s contribution represents a 75% increase in its overall revenue. It’s a game-changer.

Less noticeable is its foray into single-family homes. In its Q1 conference call, Sternlicht seemed pretty certain that Starwood will eventually spin off its residential business into its own independent, publicly traded company. Not a money-maker at this point, the real payoff comes when it sells its homes three to five years down the road.

In the meantime, it has to spend money renovating them before putting them on the rental market. But once they’re redone, the returns should be very stable.

Given Sternlicht invested $150 million[6] in TriPointe Homes (TPH[7]) in 2010, it’s clear he feels the housing market will eventually recover to where it was before the housing crisis began in 2007. And when it does, he’ll have two investment vehicles benefiting from a reinvigorated housing market. It might take some time, but it will happen.

Starwood’s 7.2% yield is about as safe as you’re going to find in the diversified REIT industry. And with Sternlicht at the controls, you’ve got one of the best real estate lenders at the helm.

Public Storage

There’s no such big yield in this pick. Public Storage’s (PSA[8]) dividend yield over the past decade has averaged 2.9%. It’s a steady payout, but that yield is well below General Electric (GE[9]) and many other large-cap industrials.

So why would you even waste your time?

Because investing is about total return and not just dividends. Over the past decade, PSA has achieved a total return of 17.6% — almost 10 percentage points greater than the S&P 500 and 5.8 percentage points ahead of its peers — and has beaten the index in seven out of the past 10 years.

With turmoil expected when interest rates increase, PSA will be the ship safely tucked in port. That’s especially important when overall markets have advanced as far as they have in 2013. Anything could set off a decent-sized correction over the coming months, and when that happens, quality is even more important.

The storage business is much like running parking lots or grass farms. Once you’ve got the property up and running, it doesn’t take a lot to keep it functioning properly. In Public Storage’s 2012 annual report, it points out that it spends about the same amount ($70 million) on maintenance capital expenditures annually for its 132 million-square-foot storage portfolio as PS Business Parks (Public Storage owns 41%) does on a 30 million-square-foot business-park portfolio.

This leads to tremendous free cash flow generation — a critical component for sustaining its 2.9% dividend yield while providing enough cash to expand its business.

It’s not sexy, but over time as the neighborhoods around PSA’s storage locations become more densely populated, the real estate becomes more valuable. Eventually, it will sell the property and locate elsewhere to start the process all over again. It’s a brilliant business if you have patience, and Public Storage has plenty. Its concept is simple: providing storage units for those experiencing downsizing, divorce, death and dislocation. With the strongest brand in storage, it simply needs to keep the doors open and the cash will flow.

However, for those who value yield over capital appreciation, Public Storage has issued $2.4 billion in preferred shares over the past 15 months through March 2013 at an average coupon rate of 5.5%. You lose some capital appreciation, but gain a little more income.

Either way, this is one of the most stable real estate investments anywhere.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.

  1. FRI: http://studio-5.financialcontent.com/investplace/quote?Symbol=FRI
  2. SPY: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPY
  3. FINVIZ.com: http://FINVIZ.com
  4. STWD: http://studio-5.financialcontent.com/investplace/quote?Symbol=STWD
  5. LEN: http://studio-5.financialcontent.com/investplace/quote?Symbol=LEN
  6. invested $150 million: https://investorplace.com/2013/05/the-best-new-homebuilder-to-make-your-own/
  7. TPH: http://studio-5.financialcontent.com/investplace/quote?Symbol=TPH
  8. PSA: http://studio-5.financialcontent.com/investplace/quote?Symbol=PSA
  9. GE: http://studio-5.financialcontent.com/investplace/quote?Symbol=GE

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