With interest rates at multi-decade lows, investors have had no other option than to move into riskier assets. P/E ratios have expanded for stocks, and opportunities are getting ever rarer for the active investor.
At the same time, we are likely to be in a late-cycle economy, and as the cycle finally turns, these high valuations are at risk of crashing down.
If you are having a tough time finding high-yielding bargains in 2019, this article is for you. We present three nichey sub-sectors that continue to offer:
- Opportunistic valuations
- Recession resilience
- High income
This is exactly what we look for at High Yield Landlord. We are value investors at heart and predominantly invest in sectors that offer high income and resilience in a late-cycle economy.
More specifically, we spend the majority of our time analyzing various “real asset” sectors, including REITs, MLPs, Infrastructure, Utilities and Energy. This is because we have found that “leasing” assets to operators is much safer and predictable than “operating” the assets yourself.
This seemingly small distinction makes a world of difference, especially during recessions. The owner of the assets participates in the profit earned by its tenants through rents that are contractually guaranteed – often for many years to come.
It protects property owners from changing market conditions, and therefore, it’s common for real asset earnings to remain perfectly steady even in a recession. This is especially true for REITs, as they own highly diversified portfolios with thousands of leases.
Consider this: Even during the sharpest real estate crash of mankind, the same-store NOI of REITs dropped by just 2%. Most tenants kept paying their rents in full and on time:
Source: Nareit T-Tracker Results 2018:Q4
This also explains why REITs (and other real asset companies) are exceptionally resilient in bear markets. With the exception of the last recession, which was caused by a housing crash, REITs have provided market-leading returns in late cycle, recessions as well as early cycles:
Source: A REIT Defense for the Late Cycle, Cohen & Steers
But not any REIT will do. Some are overpriced, and some others are too risky in a late-cycle economy. Most importantly, you need to pick the right sub-sector at the right time. In 2019, we overweight defensive property sectors that pay above average income. This includes:
- Net Lease
- Healthcare Properties
- Grocery-Anchored Shopping Centers
Each of these sectors provides an opportunity for:
- Generating high income (5-10% yield)
- Consistent growth (3-5% per year)
- Resilience in a late-cycle economy
We currently hold large positions in several companies in these sectors. Below, we provide a short overview of the opportunity in each sector.
Freestanding Net Lease Properties
“Net lease” are freestanding retail property investments, such as Dollar General (DG) convenience stores, CVS Health (CVS) pharmacies, or even Chevron (CVX) gas stations. They are some of our favorite properties because they have historically generated some of the highest returns, and yet, they have done so while being less risky and paying higher income.
Most property investments are rented with a “gross lease,” which generally comes with greater cash flow volatility. The “net lease” mitigates the risks by modifying the lease terms more in favor of the landlord:
- Very Long Lease Terms: Tenants will commonly sign an extraordinarily long lease of 10-20 years with multiple five-year extension possibilities.
- No Landlord Responsibilities: During the lease term, the tenant takes care of all property expenses and must maintain the building.
- Defensive Sectors: The businesses that occupy net lease buildings commonly operate in defensive sectors such as convenience stores, pharmacies, gas stations and quick service restaurants.
- Strong Profitability: The rent coverage ratios are generally in the 2x-4x range, making it very unlikely that tenants default on their leases. In most cases, tenants would need to see 50%-plus drops in unit profits before they would struggle to cover their rent payments.
- Protection Against Inflation: Net leases are generally tied to an inflation index or include fixed and automatic rent increases of 2% per year, or 10% every five years. Since property expenses are borne by the tenant but the rent keeps on rising, the landlord is protected against inflation.
Therefore, the cash flow is “bond-like,” and net leases are often referred to as the safest income properties for real estate investors. You have probably already heard about the two largest and most popular net lease REITs: Realty Income (O) and National Retail Properties (NNN).
They are both famous for having been exceptionally strong performers with market-beating total returns of up to 15% per year on average and consistently growing dividend payments over many decades. Not even the great financial crisis could take them down, as both REITs increased their dividends in 2008 and 2009:
Healthcare properties provide services that are insulated from the economic cycle. Property owners can rent these facilities to private operators and earn steady cash flow that is backed by strong rent coverage ratios.
There are many reasons to like hospitals as real estate investments:
- High Cash Flow – Unlike most mainstream property types such as office, industrial, retail and apartments which have experienced cap rate compression, hospitals continue to sell at a 7-10% cap rate due to the lack (relatively speaking) of institutional capital. Hospitals are big-ticket investments and require specialized expertise that is not widely available.
- Defensive and Durable – Hospitals are absolutely essential infrastructure to our society that we cannot substitute or live without for even one day. A trade war or recession is certainly not going to stop people from going to the hospital. Regardless of economic turmoil, this is a vital necessity, and therefore, such assets are perfectly insensitive to the economy.
- Strong Operators – One of the main risks of healthcare assets is that changing regulation and market landscape is putting great stress on operators, which struggle to remain profitable. There exist, however, some sub-sectors of the healthcare market that enjoy up to 3.0x rent coverage ratios. Hospitals are one of them.
- Demographic Tailwind – With rapidly aging population, the demand is expected to surpass the supply growth of well-located healthcare properties in the long run. Consider this: 10,000 Baby Boomers are reaching full retirement age every single day. No wonder, then, that the 75+ year old segment of the population is experiencing 7x faster growth than the average and is expected to account for 34 million people by 2030 (+14 million compared to today). This creates additional demand, and property owners are posed to profit in the long run.
There are many healthcare property owners to pick from. Medical Properties Trust (MPW) is the only pure-play REIT on hospitals and one of our favorite companies in this space.
Grocery Store-Anchored Shopping Centers
Not all retail properties are created equal. While a lower-quality Mall REIT such as CBL & Associates Properties (CBL) may suffer from the competition of e-commerce, this is not the case for grocery store-anchored shopping center REITs. Today, it is relatively easy to shop for clothes and other discretionary goods online, but much less so if you are looking to buy fresh food or any other service-oriented products.
Because food is such a vital necessity, grocery store-anchored properties have proven to be exceptionally resilient during recessions.
- Consistent Traffic – The average US consumer makes a trip to a grocery store 1.6 times per week, and this does not materially change in a recession. This consistent traffic then also benefits all the other tenants of the property. People need to eat whether the economy is strong or weak, and therefore, grocery store-anchored shopping centers can rely on a sustainable level of traffic regardless of economic conditions.
- Resilient Tenancy – The other tenants of grocery store-anchored properties are generally service-based and/or value-oriented. This includes fast service restaurants, dry cleaning, barber shops, and other businesses that are better insulated from the negative impact of recessions.
- Long Leases – Anchor tenants (grocery stores) will generally sign over 10-year long leases, providing consistent and predictable cash flow through the ups and downs of the market.
- High Total Return Potential – Most grocery store-anchored properties can be purchased today in the 5.5-7% cap rate range. Add to that a bit of low-cost leverage through a mortgage, and the cash-on-cash return reaches nearly 10%. Finally, a few percentage points of annual growth and your total return may approach 15% per year.
We just don’t see the internet impacting the grocery store business significantly, and despite the continued growth of Amazon (AMZN), we see no reason to worry here. As a recent report from RCM puts it:
“There is a general consensus that grocery-anchored retail centers will be around forever and, as long as they are, will be among the most attractive and highly sought-after investments… Survey participants believe that while consumers are increasing their online purchases, most are hesitant to buy groceries online. Further, when in the middle of planning and/or preparing a meal, last-minute items can’t be purchased and delivered on time when purchased online… No one can buy an ice cream cone, get their laundry, put gas in their car or check out a liquor store on Amazon…”
We agree and invest in this space through discounted REITs. There are several of them to pick from, including Kimco Realty Corp. (KIM), Brixmor Property Group (BRX) and Federal Realty Investment Trust (FRT), to name a few of the larger ones.
Building a Diversified “Real Asset” Portfolio
Net lease properties, healthcare facilities, grocery stores – along with many other real asset-backed investments – allow us to generate over $5,000 in annual passive income from a small $70,000 Real Asset Portfolio.
(Source: High Yield Landlord Real Money Portfolio)
Compared to traditional equities, our real asset portfolio also enjoys much more reasonable valuation metrics trading at:
- 9.5x cash flow on average
- 18% discount to estimated NAV
- 7.2% dividend yield (with a safe 68% payout ratio)
We expect this approach to strongly outperform traditional stocks, which are today priced at more than 23x earnings and a ridiculously low 1.8% dividend yield on average.
Brookfield Asset Management (BAM) is the pioneer in real asset investing. Here is its track record:
By positioning ourselves ahead of the expected rush to real assets, we believe that we can enjoy superior appreciation along with high income – the best of both worlds.
We are not the only ones to think so. Consider that by 2030, the capital chasing real assets is expected to increase by nearly $50 trillion. The time to act is now:
Source: Brookfield Asset Management Annual Meeting of Shareholders presentation, June 15, 2018
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Disclosure: I am/we are long MPW. 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.