Written by Nick Ackerman. This article was originally published to Cash Builder Opportunities members on October 15, 2022.
In the real estate investment trust space, you can choose from many options for generate significant and growing income from dividends. One of the most popular ways is real estate income (O), the monthly dividend company. Another choice that seems quite attractive with recent market volatility is Agree Realty (CDA).
Both of these REITs operate in the retail space, where an economic downturn would apparently impact tenants. However, most of the tenants in these REITs are financially sound, with a large portion of them being of higher quality. The types of tenants who can withstand an economic downturn. I would even say that they are relatively more insulated from economic downturns.
REITs have come under fire this year, as measured by Real Estate Select Sector SPDR (XLRE). This is despite the fact that inflation is high and generally seen as a good thing as it pushes up property valuations. For what it’s worth, ADC has held up much better, and O has certainly been competitive too, based on year-to-date total returns.
The downside of inflation is that inflation is too high, which forces an aggressive Fed to raise interest rates. Not all REITs have particularly strong rent escalations either. They can be in the low level of 1 to 2%. The other problem is that real estate prices have risen considerably and are get down now despite inflation. They don’t hold their value, at least not in the short term.
Moreover, the mere fact that they are income-oriented means that they become less interesting. If one is only looking for fixed income, treasury bills can now offer competitive returns without any risk to the principal. If one doesn’t care about the prospects for potential capital appreciation and increased income, there are safer alternatives. The 10-year Treasury last closed just over 4% on October 14.
Real estate income
Realty Income boasts that 43% of its tenants are investment grade. O also has 53 years of operating history. So they survived one or two recessions. Throughout, they have continued to focus on their strong balance sheet to produce a solid dividend record. They have 27 consecutive years of rising dividends. I would bet next year will be almost guaranteed to be 28 – whether we see a recession, a mild recession or even a deep recession.
In September, they announced another dividend increase. This is the 117th increase. These are small increases, but they really add up.
Although they have historically focused almost entirely on the United States, this has changed as they have penetrated into Europe over the past few years. This can help diversify their portfolio and create new avenues for growth.
When looking at their tenants, this is where you can see many operations that can work, even in an economic downturn. Gyms and theaters could be hotspots where consumers cut spending. However, I suspect that dollar stores, pharmacies, and other retailers like Walmart (WMT) and Kroger (KR) are essential.
They estimated that “~94% of total rent is resilient to economic downturns and/or insulated from e-commerce pressures.” This is where theaters and restaurant chains can be insulated from e-commerce as experiences you can’t order online. Although an understandable argument that streaming services could be considered competition could easily be made.
At the same time, interest rates and an overall sour market caused O shares to crash. Shares are down nearly 27% from the 52-week high. In fact, O shares just hit a new 52-week low. Looking at its estimate of fair value based on P/AFFO, we see that the stock is trading quite cheaply.
Granted, the valuation should be lower due to higher interest rates and high inflation right now. However, I believe that at this stage, it is quite excessive.
Based on its average return over the past decade, the stock is also undervalued on that basis.
Accept real estate
Agree Realty could be much smaller than O based on enterprise value. However, she too has a very promising future and trajectory. Part of this “promising future” has already been written over the past decade. They executed and delivered to shareholders.
While they cut their dividend in 2011, they have since increased it. Nor was it a significant reduction, given the economic conditions at the time.
Since they’ve only gone from strength to strength since then, the likelihood of another cut is pretty minimal, in my opinion. Analysts believe that The FFO is still awaited grow over the next few years. This includes 2023, where the FFO is estimated at $4.05.
They also just increased their dividend in October. Based on their last monthly dividend of $0.24, annualized, that equals $2.88. With this, we see that the FFO payout is around 71%. This leaves them plenty of room for dividend coverage, even if FFO declines heading into 2023 due to a recession.
ADC has also been growing FFO faster than O over the past few years. As a smaller operation, it can be easier to expand. I expect this to continue as we move forward.
ADC also boasts that 67.5% of their tenants are investment grade. Looking at their tenants, we see a lot of similarities to O. That’s definitely not a bad thing either.
They are quite exposed to “tire and auto services”. At first glance, this could be seen as a weakness. In times of economic hardship, consumers may choose to forego repairs for as long as possible. Generally this would not be advisable as it often leads to even more expensive repairs in the long run.
That being said, it can work to the advantage of auto services during an economic downturn. With less money, people could spend less on new vehicles and keep the ones they already have on the road. At least it was observed in 2009. History never repeats itself, but it often rhymes.
For ADC, we see a similar discount open regarding its fair value based on P/AFFO. That said, it is within the fair value range channel.
Based on this, this might suggest that O is a better value now. On the other hand, the anticipated growth for ADC should be even stronger. The ADC had fallen about 21% from its 52-week high.
Both O and ADC present attractive options for investing in REITs that pay monthly dividends. Both have a strong track record; even though O’s track record is longer, that doesn’t make ADC any less impressive with the success they’ve been able to achieve.
O shares have fallen more drastically, but ADC is also flirting near its 52-week low. The valuations of these two REITs have fallen significantly lately on a P/FFO basis. Yields have also increased. While it’s not risk-free like you might get with a treasury, it offers tempting future appreciation and dividend growth.