Most people will choose to retire at some point in their life. If a person has enough savings to fund the lifestyle that they desire, retirement can be a wonderful experience. However, retirement is not something that can be sufficiently planned for over just a few years. It is often necessary to begin setting aside money for retirement early and earning a strong return on that investment. Simply earning 2% on a portfolio of treasuries and other low-yield securities may not generate sufficient income or total return to achieve the savings and cash flow necessary to retire comfortably.
A Strong Total Return Fueled by Dividend Growth
A more aggressive, high-yield portfolio can generate significant cash flow, which can be reinvested into additional dividend-paying securities. These additional securities boost total portfolio cash flow, which results in an even larger amount of dividend income being reinvested the next quarter. Over time, this has a compounding effect which can produce a growing stream of portfolio income.
This growing income stream can be further enhanced by opportunistically trading out of issues that have appreciated to or above fair value and trading into issues that are more attractively priced and have a superior dividend yield. We actively manage our high yield real money portfolio in this fashion in order to capitalize on inefficiencies in the market and improve the pace of portfolio income growth as well as total return.
Another tool that we utilize in our portfolio to increase cash flow is leverage. This tool is, of course, not available in IRAs, but can be used selectively in a margin account. Buying securities on margin that do not pay a dividend results in a negative cash flow that reduces portfolio income. However, purchasing securities with a higher dividend yield than the interest expense on the margin used to purchase them produces additional positive cash flow. An example would be the purchase of a preferred stock with a 7% yield using margin interest with a 2% cost. The cash flow from the dividends fully covers the cost of the margin interest with 5% left over. If $10,000 of this preferred security was purchased on margin, the net impact would be a $500 increase in annual portfolio income. That additional income can be used to pay off some of the margin debt or to purchase additional dividend-paying securities.
It is very important to note that the use of margin increases risk and thus should be used carefully and vigilantly monitored. Macroeconomic and market factors as well as the individual risks of each security in the portfolio should be considered when determining the amount of margin to be utilized at any given time. By maintaining a well-diversified portfolio and fully considering the various risks, the margin risk can be partially mitigated. When used responsibly, margin has the potential to significantly boost portfolio income and total return.
Our Levered High Yield Real Money Portfolio
2nd Market Capital’s Growing Dividend Portfolio (2GDP) is our actively managed high yield real money REIT portfolio. With an inception date of 10/01/2019 and an initial balance of $100,000, 2GDP was created with a dual mandate of maximizing total return and dividend growth. 2GDP is set up as a margin account with interest expense at a floating rate of 2% (as of 12/31/2019). It is economically diversified, utilizes leverage and aggressively pursues opportunities to enhance total return and grow portfolio cash flow.
We have chosen this collection of REITs for our portfolio based upon their individual strengths (valuation, quality of management, dividend yield, etc.) as well as the economic and geographic diversification they provide to the portfolio as a whole. As can be seen below, our 2GDP portfolio compares favorably against the REIT Index on some key metrics.
The REITs in 2GDP trade at a weighted average discount to NAV of 9.55%, whereas the average equity REIT trades at an NAV discount of only 0.91%. The relative discount of securities in the 2GDP portfolio is particularly clear on a P/FFO basis. 2GDP trades at a weighted average FFO multiple if 8.33x (12% FFO yield), whereas the REIT Index trades at a lofty 22.07x (4.53% FFO yield).
In addition to holding more attractively priced securities, 2GDP also has a much higher dividend yield (10.23% vs. 3.65%) and more conservative payout ratio (65% vs. 80.56%) than the REIT index. With this conservative payout ratio, these REITs have more cash flow left over for debt repayment, share buybacks, (re)development or acquisitions.
2GDP’s portfolio is compared to the Invesco KBW Premium Yield Equity REIT ETF (KBWY), because the majority of the issues we research and invest in typically have small, mid or micro market capitalizations and a high dividend yield. The KBWY tracks the KBW Nasdaq Premium Yield Equity REIT Index, a dividend yield-weighted index of small and mid-cap equity REITs. The KBWY is a dividend yield-weighted ETF that is comprised of approximately 70% small and micro-cap equity REITs and 30% mid-cap REITs.
Industrial: STAG – Weight of 8.5%
The industrial sector has consistently been among the best performers in recent years both in terms of operational success and investor total return. The rise of e-commerce and the strength of the US economy have led to soaring demand, particularly for warehouse and distribution facility space. The strong industrial performance certainly warrants a higher pricing multiple than most other sectors, but the magnitude of that premium has grown so large for many of the REITs (particularly those that operate in coastal top tier markets), that we believe there is significant risk of multiple compression if growth in e-commerce and/or the US economy begin to cool down.
STAG Industrial (STAG), unlike nearly all of their peers, remains at a very reasonable multiple and is well-diversified geographically. This diversification has allowed for STAG to at times face less aggressive competition for acquisitions in tier 2 markets, resulting in very accretive transactions. CEO Ben Butcher has demonstrated stellar discipline in executing STAG’s growth strategy, consistently engaging in transactions that improve FFO/share. STAG has steadily raised their monthly dividend over recent years and future raises will contribute to the growing dividend strategy of the 2GDP portfolio.
Retail: CBL.PD, MAC, PEI – Collective Weight of 24.5%
Over the past few years, the retail sector (particularly malls) has suffered through the “retail apocalypse”, in which landlords were hit by a massive number of store closures from big box stores (such as Sears or Bon-Ton) as well as various in-line tenants. In addition to the lost revenue, these landlords have had to spend significant amounts to redevelop these properties and re-tenant them. During this transition period, same-store NOI and FFO/share have seen large declines. As the redevelopments are completed, however, the formerly vacant spaces are becoming filled with new tenants that typically have stronger balance sheets than their predecessors and are better suited to the preferences of modern shoppers.
We expect retail bankruptcies and store closures to markedly decline from the severely elevated level experienced during 2018 and 2019. We also expect that the growing trends of “clicks to bricks” (online retailers moving into physical retail such as malls) and buy online and pick up in store (BOPIS) will continue to pick up steam this year.
Additionally, many of the redevelopments that mall landlords had begun over recent years are now coming online and for many of the REITs we believe that occupancy rates will begin to tick back up as the pace of new leasing plus redevelopments coming online will outpace store closures. Not only will higher occupancy improve profitability, but the new tenant mixes (which are often mixed use and more experiential) are significantly better than the mostly apparel tenant mix that was formerly in place. Additionally, as the pace of store closures slows down and more redevelopments are completed, the amount of money that must be spent on redevelopments will continue to decline. This leaves more cash flow for better dividend coverage, debt reduction and share buybacks.
The mall sector remains risky and some REITs will take longer to turn things around than others, but we believe that the currently deeply depressed share prices represent an opportunity to pick up shares at prices far below NAV and have exceptional upside potential if mall fundamentals successfully turn around in the 2nd half of 2020 and 2021.
Pennsylvania REIT (PEI) was among the first REITs to recognize the impending trouble and got a head start on redeveloping good properties and disposing of poor ones. As a result, they are likely to be among the first to return to positive same store NOI growth potentially as early as this year. Multiple redevelopments, most notably the upscale and high traffic Fashion District in Philadelphia, have recently opened and others are expected to be completed soon as well. This will provide a substantial boost to SS-NOI and FFO/share over upcoming quarters.
Macerich (MAC) has arguably the highest quality properties of any mall REIT, averaging sales per square foot north of $700. Macerich has significantly outperformed their mall REIT peers operationally over these challenging recent years, even managing to rapidly increase sales per square foot. However, the share price has fallen from more than $65 at the end of 2017 to less than $27 at the end of 2019. This tremendous drop is not warranted and we believe presents an excellent opportunity to pick up shares at a price far below fair value.
CBL Properties Preferred D (CBL.PD) has a par value of $25, but currently trades below $5. This massive discount resulted from the suspension of the preferred dividends on December 2nd. Unlike the common dividend which had already been eliminated, the preferred dividends are cumulative and will continue to accrue for the duration of the suspension and will all be paid in full if/when the common dividend is reinstated.
Although CBL was among the last mall REITs to begin the redevelopment process and will as a result be among the last to complete this process, their properties continue to generate substantial cash flow, which has been the primary source of capital used to fund redevelopments. By suspending the preferred dividend, CBL pushed back indefinitely the date at which these dividends must be paid. Given that the dividends are cumulative but do not accrue interest, CBL essentially utilized the preferred dividend suspension as a means of attaining a 0% interest loan, the proceeds of which are being used for redevelopment and will be repaid upon the reinstatement of the common dividend.
It will be a long and difficult transition, but we believe that CBL has a good chance of successfully redeveloping their properties into urban town centers and eventually stabilizing NOI and FFO/share by the end of 2021 or early 2022. Under the REIT structure, CBL is required to pay out 90% or more of taxable income to common shareholders. Partly through the use of large property impairments, CBL is currently able to avoid a positive taxable income, and thus can temporarily escape the 90% REIT requirement. However, by 2021 CBL may run out of ways to successfully attain negative taxable income as numerous redevelopments come online. This would result in the reinstatement of the preferred dividend and the payment of all accrued dividends. With the preferred securities trading at less than 20% of par value, we believe that they have enormous upside potential and eventually huge dividend income as well.
Infrastructure: UNIT – Weight of 8.4%
In order for 5G access to expand across the country, it will be necessary to utilize high-speed fiber-optic networks. The owners of this mission critical fiber will see increased leasing demand and could see improved pricing power as well. Uniti Group (UNIT) owns a large network of fiber, more than 6 million strand miles, that spans large swaths of the country. This positions Uniti very well for growth over upcoming years. Despite this promising growth potential, UNIT trades at less than 6x consensus 2020 price/FFO.
UNIT and their largest tenant, Windstream Holdings, are currently engaged in a series of court hearings and filings as Windstream continues to move through the chapter 11 bankruptcy process. Windstream has continued to pay rent in full and on-time throughout the bankruptcy proceedings thus far. The two companies have been engaged in negotiations regarding the status of the master lease going forward. Windstream is attempting in court to recharacterize the lease as a loan, rather than as a true lease. Uniti is, of course, arguing that the lease has always been a true lease and should not be recharacterized in any way. Additionally, as per the legal handling of leases in bankruptcy, Windstream needs to decide whether to assume the lease in full or reject the lease. Given that the vast majority of the services provided (and thus revenue received) by Windstream depend upon access to the fiber and copper leased from Uniti, we believe that it is unlikely that Windstream would reject the lease. Additionally, 911 services in multiple markets are dependent upon access to Windstream’s network, because there are no other providers available in those markets. For this reason, the FCC has said that they are closely following Windstream’s bankruptcy proceedings. We believe that it is unlikely that the FCC would allow for Windstream’s coverage to terminate in those markets and for essential 911 services to therefore be lost in those markets.
As a result, we believe that the most likely outcome is that Windstream and Uniti will reach a negotiated agreement to amend the lease in a way that is somewhat less profitable for Uniti, but will allow Windstream to emerge from bankruptcy as a stronger company and thus safer tenant. There is still tremendous uncertainty regarding what decision Windstream will make regarding the lease, whether Judge Drain will approve the attempt to recharacterize the lease and what Windstream will look like when it eventually emerges from bankruptcy. Given how different the various outcomes would be for the future of Uniti, the share price is currently very depressed and will likely move significantly once these outcomes become more clear.
M-REITs: ARR.PB – Weight of 7.9%
Armour Residential REIT preferred B (ARR.PB) was selected for the portfolio due to the solid dividend yield and stable pricing. ARR.PB has a par value of $25 and is now callable. Given the stability of Armour REIT and the potential for this preferred security to be called at $25, the share price is largely rangebound at just over $25. This allowed us to buy this 7.875% preferred using margin debt with an interest rate of only 2%. This nearly 6% spread is pure additional cash flow for the portfolio.
Data Storage: IRM – Weight of 8.1%
The amount of data that must be stored is rising rapidly every year. As companies grow, so do their data storage and protection needs. In order to comply with various state and federal regulations, companies often must store physical documents as well as digital documents in the cloud. Much like private companies, government agencies have significant storage requirements. For example, police stations around the country must store large quantities of surveillance and body cam footage.
Iron Mountain (IRM) is uniquely well-positioned to serve this growing need for data storage. IRM has the capacity to store tapes and physical documents, as well as the ability to convert these documents into the Iron Cloud. IRM also has a growing portfolio of data centers in key markets. By offering such a complete set of data storage services, IRM is often able to accommodate the complete set of data storage needs of their growing customer base. As IRM is well-positioned for growth yet is priced more than 20% below NAV, there is significant upside potential to complement the nearly 8% dividend yield.
Triple Net: GNL – Weight of 8.3%
The triple net lease structure can be wonderful for landlords. Tenants are contractually obligated to pay for the property’s real estate taxes, insurance and maintenance in addition to paying for rent and utilities. Triple net leases typically have a lengthy lease term of 10-15 years and most include contractual increases to base rent each year, either on a fixed schedule or tied to some metric (ex: CPI). This provides the landlord with very consistent, growing cash flows from each of their properties.
The triple net lease structure is particularly beneficial in the current real estate environment. Property taxes are being hiked aggressively around the country and the management teams of numerous REITs have cited in their earnings calls that these tax hikes have meaningfully impacted profitability. Unlike the owners of apartments, hotels or self-storage, triple net REITs are able to pass the cost of the property tax hikes on to their tenants.
Many investors have already recognized the appeal of the triple net lease structure and investment has flooded heavily into the sector. The vast majority of triple net REITs trade at a premium to net asset value and high P/FFO multiples. Global Net Lease (GNL), however, still trades at an NAV discount and the lowest multiple in the triple net sector. With a dividend yield in excess of 10%, GNL presents a great opportunity to gain exposure to the triple net sector and boost 2GDP’s portfolio yield. GNL has the added advantage of providing geographic diversification to 2GDP thanks to GNL’s growing European property portfolio.
Office: SLG – Weight of 9.0%
The office sector is challenging, given the high vacancy rates and leasing costs (tenant improvements and leasing commissions) relative to most other property types. This challenge is further complicated by the growing trend among office workers of working from home or remotely. With the unemployment rate very low, businesses need to compete to attract and retain workers and now many are offering the flexibility of working remotely as an attractive perk. This, of course, has a negative impact on demand for office space.
As a result, we believe that in order for an office REIT to be an attractive investment, it must be both well managed and available at an attractive discount. SL Green (SLG) has a stellar management team and has achieved very impressive leasing over recent quarters. Although the share price has begun to rebound, it remains at an attractive discount to NAV and has the potential for strong price appreciation.
Health Care: GMRE, MPW – Collective Weight of 17.7%
Much like REITs in the triple net sector, health care REITs typically also sign long and favorably structured leases with their tenants. These leases also typically have escalators that steadily increase cash flow to the REIT landlord over time. Health care properties can be divided into various sub-sectors including senior housing, skilled nursing facilities (SNF), hospitals and medical office buildings.
Senior housing has seen an excessive amount of new supply as developers eagerly and aggressively prepared for the long-discussed, but not yet sufficiently materializing “silver wave” of aging Baby Boomers transitioning into senior living facilities. Until demand for these facilities starts catching up to the massive supply, we believe that the senior housing REITs are still too expensive to warrant an investment.
Skilled nursing facilities are facing not only insufficient demand, but rapidly rising labor costs. As these facilities provide a higher degree of care than senior housing, they require staff with specific training and licensing. With the unemployment rate so low, these facilities have had to continuously raise wages or risk losing much-needed staff. These dual challenges have led to very poor EBITDARM coverage ratios among many SNF operators. Until fundamentals meaningfully improve in the SNF industry, we believe that the risk is too great to warrant current pricing for SNF REITs.
Hospitals are an essential asset class in every community and with a good operator can be very profitable. There is, however, always legislative risk given that changes to Medicare reimbursements or other legal policies could impact hospitals. It is therefore important to have geographic diversification in this space so as to mitigate the risk of potential changes in a particular state or even country. Medical Properties Trust (MPW) is the only pure play hospital REIT and it has both an excellent management team and increasingly strong geographic diversification. MPW announced in December that they will acquire, for approximately $2 billion, an additional 30 hospitals in the United Kingdom under a long-term inflation-protected net lease agreement. MPW has steadily raised the dividend and we believe that it will continue to provide solid dividend growth in the future.
Medical office buildings have arguably the strongest fundamentals in the health care sector right now. The tenants of these facilities are benefitting greatly from an increasing trend among patients toward outpatient care. Global Medical REIT’s (GMRE) well-located portfolio of medical office buildings is thriving in this favorable environment. With strong earnings growth potential and a solid dividend yield of nearly 6%, this well-managed REIT fits nicely into the 2GDP portfolio.
Corrections: GEO – Weight of 7.6%
The two largest private prison operators are both REITs, Corecivic (CXW) and GEO Group (GEO). They have contracts with multiple federal agencies (Bureau of Prisons, Immigration and Customs Enforcement and the US Marshalls) as well as with state and local governments. Both REITs have performed exceptionally well operationally, but the share prices have been driven down by a very aggressive campaign by political activists and politicians against the use of private companies to house and provide services to those who are incarcerated. All of the top tier Democrat candidates for president have expressed intentions to curb or end the use of federal government contracts with for-profit operators. If one of those candidates gets elected, this could potentially limit the signing of new federal government contracts for the duration of their presidential term.
Thankfully, many of the in-place contracts have very long maturities, continuing to provide cash flow even in this downside scenario. Although both prison REITs are well-managed and attractively priced, we have selected GEO for the 2GDP portfolio due to the well-covered nearly 12% dividend yield and international exposure.
Important Notes and Disclaimer
The information contained herein is confidential, privileged and only for the information of the intended recipient and may not be used, published or redistributed without the prior written consent of 2nd Market Capital Advisory Corporation (2MCAC).
Suitability: The information contained herein is impersonal and not tailored to the investment needs of any particular person. It does not constitute a recommendation that any particular security or strategy is suitable for a specific person. We cannot determine whether the portfolio holdings presented are suitable for any given reader. Readers are encouraged to contact their financial professional to discuss the suitability of any strategies or holdings prior to implementation in their portfolio.
Forward-looking statements: Commentary may contain forward-looking statements which are by definition uncertain. Actual results may differ materially from our forecasts or estimations, and 2MCAC cannot be held liable for the use of and reliance upon the opinions, estimates, forecasts, and findings in these documents.
Holdings: The specific securities identified and described herein do not represent all of the securities purchased or sold for advisory clients of 2MCAC. It should not be assumed that investments in the securities identified and described were or will be profitable. The holdings presented were the entire holdings of 2GDP as of 12/31/19, but may not represent the holdings for other time periods. We do not intend presentation of 2GDP’s holdings as a recommendation, but rather as a statement of historical fact. It should not be assumed that purchases and sales made in the future will be profitable or will equal the performance of the securities in this list.
Past Performance does not guarantee future results. Investing in publicly held securities is speculative and involves risk, including the possible loss of principal. Historical returns should not be used as the primary basis for investment decisions. The performance described represents the 2GDP portfolio only and does not represent the performance of all advisory clients. Although the statements of fact and data in this commentary have been obtained from sources believed to be reliable, 2MCAC does not guarantee their accuracy and assumes no liability or responsibility for any omissions/errors.
Benchmark Comparison: 2GDP’s portfolio is compared to the Invesco KBW Premium Yield Equity REIT ETF (KBWY) because the majority of the issues we research and invest in typically have small or micro market capitalizations and a high dividend yield. The KBWY tracks the KBW Nasdaq Premium Yield Equity REIT Index, a dividend yield-weighted index of small and mid-cap equity REITs. The Invesco KBW Premium Yield Equity REIT ETF (KBWY) is a dividend yield-weighted ETF that is comprised of approximately 70% small and micro-cap equity REITs and 30% mid-cap REITs. The KBWY excludes Mortgage REITs, overweights commercial REITs and underweights residential REITs. The KBWY is calculated with dividends reinvested. The 2GDP portfolio’s dividends are reinvested.
Strategy and Market Conditions: 2GDP uses a bottom up stock selection process which may fare better in certain market conditions than in others. It may perform better when value is in favor or worse when value is out of favor.
Expenses: Returns reflect the deduction of any transaction expenses. There are no costs or management fees charged nor deducted.
Calculation Methodology: Partial year return, unaudited. Dividends in 2GDP are reinvested.
Use of Leverage: 2GDP intends to use leverage (typically described as margin), thereby increasing both the possibility of gains and the risk of loss. Margin limits are capped at 2:1 or 200% of borrowings against net equity. Margin levels are anticipated to range from 0% to 200% of borrowings against net equity. As of 12/31/2019 2GDP’s cost of margin capital is 2.0%. 2GDP’s margin rate was negotiated directly with the custodian; subscribers’ cost of margin may be higher.
Conflicts of Interest. We routinely own and trade the same securities purchased or sold for advisory clients of 2MCAC. This circumstance is communicated to clients on an ongoing basis. As fiduciaries, we prioritize our clients’ interests above those of our corporate and personal accounts to avoid conflict and adverse selection in trading these commonly held interests.
For a full toolkit on building a growing stream of dividend income, please consider joining our marketplace, Retirement Income Solutions. With our service you will get:
Access to Two Real Money REIT Portfolios Real Time Trade Alerts Weekly Market Commentary Monthly Portfolio Analytics
We welcome you to test it out with a free 14 day trial.
Disclosure: I am/we are long ARR-B, STAG, MAC, CBL-D, PEI, UNIT, IRM, GNL, AFIN, SLG, GMRE, MPW, AND GEO. 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.
Additional disclosure: 2nd Market Capital and its affiliated accounts are long ARR-B, STAG, MAC, CBL-D, PEI, UNIT, IRM, GNL, AFIN, SLG, GMRE, MPW, and GEO. I am personally long STAG, MAC, CBL-D, PEI, UNIT, IRM, GNL, GMRE, MPW, and GEO. This article is provided for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer. Information contained in this article is impersonal and not tailored to the investment needs of any particular person. It does not constitute a recommendation that any particular security or strategy is suitable for a specific person. Investing in publicly held securities is speculative and involves risk, including the possible loss of principal. The reader must determine whether any investment is suitable and accepts responsibility for their investment decisions. Simon Bowler is an investment advisor representative of 2MCAC, a Wisconsin registered investment advisor. Commentary may contain forward-looking statements that are by definition uncertain. Actual results may differ materially from our forecasts or estimations, and 2MCAC and its affiliates cannot be held liable for the use of and reliance upon the opinions, estimates, forecasts, and findings in this article. Positive comments made by others should not be construed as an endorsement of the writer’s abilities as an investment advisor representative.