How REITs can protect your portfolio
The inflation rate in the U.S. spiked to 9.1% in June 2022, the highest level since 1981. Across the pond in the U.K., inflation is also heating up and recently came in at 7.9%. In order to curb this high inflation in both the U.S. and the U.K., the central banks of both countries are gradually raising interest rates. Higher interest rates are bad news for many stocks as it increases the discount rate and compresses valuation multiples for growth stocks.
However, historically during high inflation periods, real estate has done well and acted as an inflation hedge. Thus, as investors it makes sense to look into Real Estate Investment Trusts (REITs). These entities own brick and mortar real estate but trade just like stocks, meaning they are highly liquid and investors can own a small slice.
The beautiful thing about REITs is they must pay out 90% of taxable profits to shareholders as a dividend distribution, which means they are great for income investors. In addition, there are also many tax advantages. For example, individual REIT shareholders can deduct 20% of the taxable REIT dividend income from rental income profits. In this article, I reveal two of my favorite REITs, one in the U.S. and one in the U.K., for investors to consider as potential inflation hedges.
Disclaimer: This article is not investment or tax advice. Investors should always do their own due diligence.
Apartment Income REIT
Dividend Yield: 4.4%
Guru Investors: Joel Greenblatt (Trades, Portfolio), Jeremy Grantham (Trades, Portfolio), Jim Simons (Trades, Portfolio)
Apartment Income REIT Corp. (AIRC, Financial) is the perfect REIT to play the trend of the increasing number of single people who are buying a house and getting married later than prior generations. This higher number of single people is why younger generations tend to prefer a nice apartment in a city location, as opposed to a large suburban home.
Apartment Income REIT, also known as Air Communities, owns 75 multi-family properties which have over 25,000 apartments across the U.S. Below is a slide from the company showing its apartment locations:
The company recently acquired two new luxury apartment developments in Miami and Biscayne Bay, Florida. These offer tenants a host of facilities which include a health and wellness center in addition to a rooftop pool.
Management cultivates a culture of “customer focus" with the customers in this case being the property tenants. Its properties have a strong customer satisfaction (CSAT) score of 4.33 out of 5, which has been trending up since 2018.
The REIT has also generated strong financials with its net operating income (NOI) growing at a much faster rate than the coastal peer average [in blue], which is fantastic to see. Management is confident on future revenue growth, estimating a 9.8% growth rate, which is higher than the coastal peer average of 9.2%.
The company is also showing great efficiency and generated a same store revenue to free cash flow conversion rate of 65.3% in the first quarter of 2022, which was substantially higher than the coastal peer average.
In terms of valuation, the GF Value line indicates a fair value of $41 per share, meaning the stock is fairly valued at the time of writing.
Value investor Joel Greenblatt (Trades, Portfolio) was buying the stock in the first quarter of 2022, during which shares traded at an average price of $52 apiece, which is 20% higher than where the stock trades currently.
Apartment Income REIT also has a price-to-funds-from-operation ratio of 17.2, which is cheaper than many industry peers. For example, AvalonBay Communities (AVB, Financial) trades at a more expensive price-to-funds-from-operation ratio of 20.2, as does Camden Property Trust (CPT, Financial) at 20.6.
British Land
Dividend Yield: 5.42%
British Land (LSE:BLND, Financial) is one of the largest REITs in the U.K. that focuses on property development. The company has approximately 70% of its properties mainly in the London area and is diversified across campuses (64%), retail (33%) and urban logistics (3%). (Note: "campuses" refers to non-retail business properties).
Its tenants include an elite list of well established companies. Its largest tenant is Meta (META, Financial), formerly known as Facebook, which makes up 17.4% of campus rent, followed by Dentsu (TSE:4324, Financial), one of the world's largest marketing companies, and then payments giant Visa (V, Financial). Other tenants include Microsoft (MSFT) and Softbank (TSE:9434, Financial). The quality of the REIT’s top tenants should give investors peace of mind that they will “make the rent” as their businesses are powerhouses.
Recently, campus properties saw occupancy rates improve to 86% and retail parks also saw a 270 basis points improvement in occupancy to 97.4%, which is fantastic. The company’s “total accounting return” was historically a fantastic 14.8%, driven by a 5.7% increase in retail park value plays and a 2% boost in development profits.
Moving forward, British Land is on track for strong project returns with a base case internal rate of return (IRR) of 10% to 12%. In addition, 91% of its contracted costs are already fixed, thus this should help mitigate against inflation effects.
In terms of valuation, British Land has a portfolio value of 10.5 billion British pounds ($12.6 billion), up 6.5% since March 2021. The company has a market cap of £4.3 billion and thus is trading below this value.
However, I believe it’s best to take into account the substantial £3.14 billion in debt and £96 million in cash. Thus, we get an enterprise value of £6.48 billion. With a portfolio value of £10.5 billion, the stock is approximately 38% undervalued on an asset value basis.
Final thoughts
REITs are a great way to expose your portfolio to the real estate with limited downside risk. The asset class is well-known to act as an inflation hedge, pays out income and is also very tax efficient. Apartment Income and British Land could thus be worth considering for investors worried about inflation protection.
