American Assets Trust: Long-Term Perspective During Downturn

About a year ago, I recommended purchasing American Assets Trust (NYSE:AAT) for its promising growth potential and its reasonable valuation. Since my article, the stock has declined 27% due to the unforeseeable war in Ukraine, which has caused a surge of inflation to a nearly 40-year high level. High inflation is likely to increase the interest expense of the REIT while it also has a negative effect on the price-to-FFO of the stock, as it reduces the present value of future cash flows. Nevertheless, American Assets Trust has proved resilient in the highly inflationary environment prevailing right now, with record FFO per unit in 2022. As it is trading at a nearly 10-year low trailing price-to-FFO ratio of 11.6, it is likely to highly reward the investors who can wait patiently for inflation to subside.

Business overview

American Assets Trust has 56 years of experience in acquiring and developing office, retail and residential properties in Southern California, Northern California, Oregon, Washington and Hawaii. It generates 58% of its revenues from office properties, 25% from retail properties and the remaining 17% from its multifamily units.

Most REITs carry appreciable amounts of debt and hence they have been significantly affected by the surge of inflation to a nearly 40-year high. Due to excessive inflation, the Fed has been raising interest rates aggressively. Consequently, when REITs face debt maturities, they will have to refinance their debt at much higher interest rates. This means that their interest expense is likely to rise significantly in 2023-2024.

However, American Assets Trust has a manageable amount of debt and thus it is much more protected from the headwind of high interest rates than most REITs. American Assets Trust has an interest coverage ratio of 1.9 and net debt (as per Buffett, net debt = total liabilities – cash – receivables) of $1.6 billion. This amount is not negligible but it is 76% of the market capitalization and 9 times the annual FFO of the REIT. Therefore, it is manageable.

Moreover, management recently stated that it aims to reduce the leverage ratio (Net Debt to EBITDA) from 6.4 to below 5.5. Furthermore, the trust has a well-laddered schedule of debt maturities.

As shown in the above chart, only $250 million of debt matures within the next two years. As a result, the effect of high interest rates on interest expense is likely to remain under control for the foreseeable future.

Apart from the headwind of high interest rates, American Assets Trust is facing another negative factor, namely the work-from-home trend. Most companies adopted a work-from-home model at the peak of the pandemic but this trend was expected to fade over time. The pandemic has subsided and thus many companies have called their employees back to the office. Nevertheless, a significant number of companies still operate with a work-from-home or a hybrid model. This is undoubtedly negative for American Assets Trust, which generates 58% of its revenues from its office properties.

However, the REIT has already begun to experience improvement on this front in most of its markets. In addition, management recently stated that it has received positive feedback from several employers, who intend to call their employees back to their desks this year. Many large companies, including Apple (AAPL), Morgan Stanley (MS) and Disney (DIS), have asked their employees to return to their offices lately. To cut a long story short, American Assets Trust has significant growth potential thanks to the expected return of employees to their offices.

It is also important to note that American Assets Trust has proved exceptionally resilient to the ongoing downturn in its business. In the third quarter, the REIT grew its same-store net operating income by 11.3% and its FFO per unit by 11% over the prior year’s quarter, primarily thanks to strong rent hikes in most of its markets. As a result, the trust raised its guidance for its annual FFO per unit from $2.21-$2.27 to an al-time high of $2.30-$2.34. At the mid-point, the revised guidance implies 16% growth over the prior year. The impressive growth rate and the record FFO per unit are testaments to the strength of the business model of American Assets Trust.

It is also worth noting that American Assets Trust has an exceptional performance record. To be sure, the REIT has grown its FFO per unit every single year over the last decade, except for 2020, when it posted a 14% decrease in its bottom line due to the pandemic. A 14% decrease in FFO per unit amid a fierce downturn is certainly benign. Even better, American Assets Trust expects significant growth in the upcoming years thanks to its new developments at Waikiki Beach Walk Retail and Embassy Suites and the recovery of tourism in Hawaii from the pandemic.

Valuation

American Assets Trust is currently trading at a nearly 10-year low price-to-FFO ratio of 11.6. This is much lower than the 5-year average price-to-FFO ratio of 18.7 of the stock. The exceptionally cheap valuation has resulted primarily from the surge of inflation, which has significantly reduced the present value of future cash flows. In fact, excessive inflation is the primary reason behind the ongoing bear market of the entire stock market.

However, the Fed has raised interest rates at an unprecedented pace in order to restore inflation to its target level of 2%. The aggressive stance of the central bank has already begun to bear fruit, as inflation has moderated every single month since it peaked last summer. As the Fed has explicitly prioritized restoring inflation to normal levels, it is likely to achieve its goal sooner or later. When inflation reverts to normal levels, the price-to-FFO ratio of American Assets Trust is likely to revert towards its historical levels. This means that the stock has great upside potential (61% = 18.7/11.6-1) merely thanks to the normalization of its valuation level.

Dividend

Due to its exceptionally cheap valuation, American Assets Trust is currently offering a nearly 10-year high dividend yield of 4.7%.

The REIT has a reasonable AFFO payout ratio of 77%, which is likely to improve in the upcoming years thanks to the expected recovery of the business of the REIT. Given also the aforementioned manageable amount of debt of the trust, the dividend seems to have a meaningful margin of safety for the foreseeable future.

Risks

The primary risk of American Assets Trust is the adverse scenario of persistently high inflation for years. In such a case, interest rates will remain high for years and thus the stock will be hurt by increased interest expense and a cheap valuation level. However, thanks to the determination of the Fed, this scenario is highly unlikely.

Another risk factor is the adverse scenario of a prolonged recession, which might be caused by the aggressive policy of the Fed. In such a case, the demand for the properties of American Assets Trust is likely to be poor. However, the Fed is much more active nowadays than it used to be decades ago. It is now trying to cool the economy in order to reduce inflation but it will adjust its policy if it cools the economy too much and causes a severe recession. Overall, a recession may occur but the Fed is not likely to allow a severe recession to last for years.

Final thoughts

American Assets Trust is trading at a nearly 10-year low price-to-FFO ratio while it is offering a nearly 10-year high dividend yield of 4.7%. The REIT is currently facing some headwinds, namely the somewhat persistent work-from-home trend and sky-high inflation, but these headwinds are likely to attenuate in the upcoming years. As a result, the stock is likely to highly reward patient investors, who can maintain a long-term perspective during the ongoing downturn.