Cash Flow Is King: Why You Never Want To Be All In No ratings yet.

In order to properly discuss why you always want some cash on hand as an investor, let’s discuss the news.

Oh, the news. Always such a great source of gloom and doom to dampen your morning, afternoon, and evening enthusiasm.

No doubt, you have your own mental collection of trouble-trumpeting titles to turn to. But these are just a few of the headlines I’ve seen across a few of the platforms I’ve visited in recent days:

  • AP – “Wide Implications as Germany Teeters Toward Recession”
  • The Wall Street Journal– “Trump Calls for a Big Fed Rate Cut, Again Criticizes Central Bank Chairman”
  • MarketWatch – “Disney Whistleblower told SEC the company inflated revenue for years”
  • CNN – “Alligators caught climbing fences and swimming across roads in Florida.”

Who knew alligators could climb fences? Especially big, bulky seven footers? They actually have video footage of one such monster scaling a naval air station’s supposedly secured perimeter.

I’ve never heard of that happening before. And I live in South Carolina!

Admittedly, I live pretty far inland outside of these giant reptiles’ natural habitat. But still. It just goes to show you that anything can happen.

And when anything can happen, it’s good to be prepared for a lot.

No Doomsday Prepping Here

Notice how I said “a lot,” not “everything.” Go out and buy a bunker if you think that’s what’s best. But don’t go blaming me if the investment doesn’t pay off.

Bunkers, zombie-apocalypse survival kits, and 40-pound freeze-dried food prepper packs are not in my recommended portfolio. Not on the free site, and not on iREIT on Alpha either.

I stick to stocks here, with the occasional alligator mention thrown in for good measure.

Here’s what I’m trying to say: You really and truly can’t ever predict what’s going to happen in the future. For all we know, the Earth might stop turning tomorrow and the sun won’t “rise.”

Or our favorite portfolio position could suddenly be under investigation for major financial fraud, as could be the case with Disney (NYSE:DIS). The previously pointed-out MarketWatch story reports that:

“A former Walt Disney Co. accountant says she has filed a series of whistleblower tips with the Securities and Exchange Commission alleging the company has materially overstated revenue for years.

Sandra Kuba, formerly a senior financial analyst in Disney’s… revenue-operations department who worked for the company for 18 years, alleges that employees working in the parks-and-resorts business segment systematically overstated revenue by billions of dollars by exploiting weaknesses in the company’s accounting software.”

Disney abjectly denies the allegations, of course, but the point is: Nobody saw this coming and nobody knows how it will end.

If they did, they could make a mint.

Enough Cash on Hand to Deal With the Bad and Capitalize on the Good

I don’t mean to pick on Disney (even if it did release a certain movie in 2016 with a certain song that gets stuck in your head far too easily and far too often). Again, that’s just a recent headline that caught my attention.

In Disney’s defense, there are a lot of other attention-grabbing news stories out there, such as those about:

  • The ongoing disagreement between President Trump and the Federal Reserve.
  • The ongoing trade war between the U.S. and China.
  • The ongoing dispute between China and Hong Kong, which could easily turn violent.

On that last one, The Los Angeles Times notes how:

“In recent weeks, authorities have ramped up pressure on protesters in Hong Kong, calling their demonstrations ‘terrorism’ and hinting at Chinese military intervention. With Chinese troops hovering just outside Hong Kong, U.S. national security advisor John Bolton has warned Beijing to avoid a new Tiananmen Square moment, a provocative reference to the massacre of Beijing protesters 30 years ago.

What are the tough tactics and could they backfire, locking authorities and protesters in a cycle of violence?”

How things are going to end in is up in the air. It’s a volatile situation in a volatile era that could do anything to volatile global financial markets.

That’s why you want to have cash on hand. Because, as we’ve already said, you just don’t know what’s up ahead. You don’t know what you’re going to have to pay for, fix, replace, or otherwise deal with.

For that matter, you just don’t know what’s up ahead in a more positive light. What quality stocks might take brief falls from grace, turning them into prime buying opportunities? If your money is fully invested already in stocks, bonds and the like…

You might not have enough time to maneuver your finances around appropriately to snatch them up.

Enter REITs…

REITs have performed extremely well year-to-date, up over 20% and yielding around 4% on average. That’s nearly double the S&P 500’s 2% yield. It also means that REIT valuations are inching up – around 18x their price to adjusted funds from operations (P/AFFO) – trading close to their long-term valuation multiple (around 18-19x AFFO).

However, according to Citi Research, the dividend payout ratio for REITs (using AFFO) “is about 75%, below its historical average of just under 80%.” And as Michael Bilerman, head of U.S. real estate and lodging at Citi Research, concludes, “The reality is that the payout ratios are low, which allows companies to retain free cash flow and protect their dividends.”

He added that, “The amount of capital that has been raised to both buy and finance real estate is at a record that provides good support for the industry at large.”

Given the run-up in REIT valuations, we decided to put together a list of five high-quality REITs we recommend today. We’re also including a list of five high-quality REITs that we recommend buying when there’s a pullback.

It’s always good to have your dry powder list ready, so we’ll call that second set the “dry powder” list. But let’s start with the most actionable list of REITs we recommend now…

Source: iREIT

Digital Realty: Ready to Move Again?

Digital Realty (DLR) is a data center REIT that we’ve been covering for quite a while (since February 2013).

Recently, it was reported that CyrusOne (CONE) was exploring a sale to a private consortium such as KKR, Stonepeak, or I Squared Capital. However, in a Marketplace memo, I explained that “there could be a bigger deal brewing, and one that could involve the big bad data center dynamo called Digital Realty.”

Here’s a little more from that published piece:

“Given Digital Realty’s cost of capital today, it seems logical that the company would pursue CyrusOne… in doing so, it would get a best-in-class development arm. (Also, reading the tea leaves, Healthcare Trust of America was able to acquire Duke Realty’s MOB portfolio that also included development growth prospects.)”

Regardless of how it plays out, the CyrusOne news provides some relevance to the data center sector. In our opinion, Digital Realty is a perfect buyer given its business model, scale, and balance sheet, as well as the potential accretion from CyrusOne due to its multiple integration prospects.

Digital Realty is trading now at $124.33 per share. It has a well-covered dividend yield of 3.5% and a P/FFO multiple of 18.7x.

Make no mistake of it: Digital isn’t a bargain. But we believe there could be a deal in the making. Possibly two! This REIT is well positioned to continue its dominance as the data center consolidator.

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Source: F.A.S.T. Graphs

Physician’s Realty: A Bit Bruised but Ready for a Comeback

Physicians Realty (DOC) recently reported Q2-19 earnings that missed consensus, largely as a result of its LifeCare and Foundation El Paso tenants.

Specifically, it recognized $9.4 million of lost rental revenue. LifeCare filed for Chapter 11 bankruptcy in May, and DOC didn’t receive rent in either April or May, totaling $0.80 million. As such, it had to write off straight-line rent of $3.5 million.

LifeCare resumed contractual rent payments in June, and the new owner has agreed to assume the master lease as-is.

DOC also had to write off $2.1 million past-due cash rent and $3 million straight-line rent on the Foundation El Paso surgical hospital. DOC expects to sell the hospital instead of re-tenanting the space.

Annual cash net operating income (NOI) was about $2.9 million. And the combined FFO impact to both properties is estimated to be around $0.05/share per quarter. It should bounce back to above $0.04/share as the write-off is removed and LifeCare resumes paying rent.

Although full-year 2019 FFO will be lower than originally forecasted – we estimate it down from $1.06/share to $1.02) – we consider the dividend safe based on the company’s payout ratio and historical capital markets discipline. DOC expects to generate 2%-3% annual cash NOI growth and 4%-5% funds available for distribution in 2020.

Its current P/FFO is 17.1x vs. a norm of 19.5x, making a valuation gap with an attractive margin of safety. Folks can therefore take advantage of this well-covered 5.2% yielding REIT.

DOC is trading at $17.76 per share.

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Source: F.A.S.T. Graphs

Simon Property Group: An A-Rated REIT

Simon Property Group (SPG) is the only A-rated S&P 500 REIT on the buy list… which perhaps makes it our overall top pick today.

As I explained in a recent article, Simon has “managed to achieve 14% annualized returns over a quarter-century with 60% overall less volatility than the S&P 500.” This is impressive, especially since the current discount “offers the realistic potential for 11% to 18% CAGR (compound annual growth rate) total returns, which is slightly above the REIT’s 25-year track record.”

As I’ve often said, if you’re going to invest in malls, make sure that their owner has adequate capital to redevelop. So while, say, Washington Prime’s (WPG) 29.5% dividend yield seems alluring… investors must recognize that the potential for a dividend cut is quite high.

Prudent investors should recognize that the key to success is liquidity. And with nearly $7 billion in low-cost liquidity, Simon’s competitive advantages make it an easy choice today.

In my article referenced above, I wrote how, “Even assuming just 4% long-term growth from Simon, the 5.5% yield and modest multiple expansion creates 11% CAGR total return potential over the next five years.”

That’s an evaluation I stand by.

Simon shares are trading at $149.96, which translates into a P/FFO of 12.2x against a norm of 14.5x. Its dividend yield, meanwhile, is 5.6%.

To put that into perspective, I’ll quote myself one more time…

“11% to 18% CAGR return potential basically means Simon can realistically double your money, including very safe dividends, within five years.”

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Source: F.A.S.T. Graphs

Iron Mountain: an Attractive Oddball

Iron Mountain (IRM) is a true “outlier” in the REIT sector and perhaps one of the most misunderstood high-yielding companies in my coverage spectrum.

While most recognize it for its boxes and trucks, many don’t grasp the other parts of its business model… which includes shredding, digitization, and data-center storage.

In a recent article, Rida Morwa said that “IRM is worth in excess of $36, or 20% higher from here.” For our part, we estimate its net asset value at around $40 per share. (The Sentieo consensus NAV is $42.10).

Shares are now trading at $31.95, which is a substantial discount from its average $38 price (of me and Rida).

For the record, I do recognize the challenges for Iron Mountain to close the valuation gap. They include improving leverage and growing the dividend by 4% to 6% per year. To make that happen, the company needs to grow AFFO by 4% or higher in 2020.

If it can, that should provide shareholders with solid total returns, estimated to be 12%-15%.

Iron Mountain is trading at 10.4 P/AFFO, and its dividend yield is 7.6%. Keep in mind that its revenue stream is highly diversified, with 230,000 customers across 53 countries located throughout six continents – including more than 95% of the Fortune 1,000 list.

Those numbers provide it with highly durable income.

A screenshot of a social media postDescription automatically generatedSource: F.A.S.T. Graphs

Ladder Capital: This One Stays a Buy

Ladder Capital (LADR) is one of my favorite commercial mortgage REITs. One of the reasons why I like this particular company so much is because it’s internally managed.

In fact, as I wrote earlier this year:

“Management and directors own $242 million of LADR stock (11.5% of total equity market cap). And lending is the sole focus of the management team – (which is) unique to the sector…

The core team members have worked together for over two decades, and the expertise of the fully integrated investment team is one of the most valuable assets (five members of the management team have 146 years of cumulative experience).”

Another advantage is deal size. Ladder’s average loan size is around $20 million, with a focus on mid-market lending. Most of its peers focus on much larger deals, so these smaller loans provide the REIT with added diversification.

There’s always going to be a problem loan here or there. But Ladder has an extremely loyal customer base – with more than 50% of balance sheet loans being made to repeat borrowers. It also has a diversified lending platform, so it can easily deploy capital in the property sectors that offer the best risk-adjusted returns.

Ladder has three main business lines: Lending, investment-grade-rated securities, and real estate equity (mostly net lease). Together, these add up to over $6 billion of assets. This multi‐cylinder approach is inherently safer than a monoline approach, not to mention better able to produce profits through cycles and a wide range of market conditions.

Ladder currently yields 8.1% with a price-to-earnings ratio (P/E) of 9.4x. As of Q2-1, its dividend remained well covered with a quarterly payout ratio of 79%. That yield allows it to retain 21% of core earnings.

Better yet, as founder and President Pamela McCormack put it, this latest quarter was characterized by “strong earnings, steady ongoing loan origination, and investment activity with a continued focus on conservative credit metrics.” Keep in mind that if Ladder adopted a similar payout ratio to its peers, the yield would be about 100 basis points higher than the sector.

For all those reasons, we maintain a Buy status on this pick.

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Source: F.A.S.T. Graphs

The Dry Powder List…

As I said earlier, many REITs have become more costly to own… hence why we’re recommend holding some dry powder for future use.

In that regard, I’ve included a list of REITs we recommend buying on a pullback: Mid America Apartment (MAA), Crown Castle (CCI), Realty Income (O), Ventas Inc. (VTR), and STAG Industrial (STAG).

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As you can see below, all these REITs are trading above our Fair Value price range:

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Of course, there are few complaints with those price hikes on iREIT’s end. Except for MAA, we own all of them already, and they’ve provided strong results for us year to date.

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We own these five REITs (except MAA now) because of their stable earnings profile and reliable dividend growth. Here’s a snapshot of their analyst-consensus forecasted estimates for 2019 and 2020:

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In Closing…

Investors should be mindful that the longer the economy stays strong, the greater the chance of the law of averages kicking in. In other words, there will be some kind of correction at some point.

The key is to maintain a balanced portfolio and prepare for the volatility by maintaining adequate cash. Each investor should abide by his or her own risk profile. A lot also depends on individual goals and timetables.

Given the highly predictable nature of dividend income from REITs, we recommend an allocation of 10% to 20% – again, based on your overall risk tolerance profile.

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Author’s note:Brad Thomas is a Wall Street writer, which means he’s not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: written and distributed only to assist in research while providing a forum for second-level thinking.

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While we’ll continue providing our free sector reports, iREIT subscribers will now get exclusive access to our expanded real estate coverage including:

  • Expanded REIT Rankings Reports With Exclusive Content
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Disclosure: I am/we are long DLR, DOC, SPG, IRM, LADR, VTR, O, CCI, STAG. 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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