VNQ: The Good, The Bad, And The Ugly

The stock market bottomed in October 2022, but since then, equities have seen a nice rebound with all major averages in the green. Here is those returns over the past three months:

• Dow Jones Industrial Average: +10.3%
• S&P 500: +7.0%
• Nasdaq: +4.7%
• Russell 2000: +8.5%

This has been a welcomed sign for investors.

A lot of the turnaround has coincided with the Fed implying a slowdown in the pace of rate hikes moving forward. This not only bodes well for equities in general, but it also bodes well for the REIT sector.

Over the past three months, the Vanguard Real Estate ETF (NYSEARCA:VNQ) has outpaced all the major averages with a return of 12.7% over the same three-month period.

REITs are a great total return investment and they have been a top performing asset class for decades.

However, the past three years, since the global pandemic hit the states, REITs have been under pressure and have lagged the major indexes. In fact, over that three-year period, REITs are negative.

When it comes to stocks, individual stock picking can be both difficult and time consuming. Individual stocks pose a higher risk as well as higher reward. If you have read our articles in the past, we focus on individual stocks a lot as we are in the markets every day.

Another option for investors are ETFs or Exchange Traded Funds.

Think of ETFs as a basket of stocks. These baskets come in all shapes and sizes and have different strategies. Some ETFs focus on tracking indexes, some focus on specific sectors or some even focus on dividends or growth, among other types. Due to this, ETFs can be more of a hands off investment.

Building a portfolio of both ETFs and individual stocks can prove to be a great strategy. The foundation of a successful portfolio is often focused on ETFs with individual stocks sprinkled around.

Looking for exposure to Real Estate via REITs, one could look at the most popular REIT ETF, which is the Vanguard Real Estate ETF.

The Makeup of VNQ

Vanguard Real Estate ETF is an exchange traded fund launched and managed by The Vanguard Group, Inc. It invests in public equities within the US real estate sector. The ETF seeks to track the performance of the MSCI US Investable Market Real Estate 25/50 Index, by using a full replication technique. The ETF was formed back in May 1996.

The Vanguard Real Estate ETF has $35 billion of assets under management which is made up of 171 positions.

The top 10 positions and their weightings within the fund are as follows:

1. Vanguard Real Estate II Index: 12.14% weighting
2. Prologis (PLD): 7.35%
3. American Tower Corp. (AMT): 6.96%
4. Equinix Inc. (EQIX): 4.21%
5. Crown Castle Inc. (CCI): 4.15%
6. Public Storage (PSA): 3.13%
7. Realty Income Corp. (O): 2.77%
8. Simon Property Group Inc. (SPG): 2.64%
9. SBA Communications Corp. (SBAC): 2.13%
10. Welltower Inc. (WELL): 2.07%

The top position, the Vanguard Real Estate II Index, is a Real Estate index fund with many of the same top 10 positions, as such we will focus on those remaining 9 individual REITs.

The top 10 positions make up 43% of the entire portfolio. Let’s take a look at valuation for each of these individual REITs.

As you can see from the chart above, many of these REITs are trading at FFO multiples that are below their historical 5-year average. Seven of these top positions are rated a BUY or higher at iREIT on Alpha.

Prologis

Prologis is a real estate investment trust (REIT) that has the largest market capitalization of any REIT with a current market cap of 117.4 billion. Prologis is an A investment-grade rated company with a fortress balance sheet.

At year-end 2022, Prologis had $3.8 billion available to them under their credit facilities and $278 million in cash and cash equivalents for a total liquidity of $4.1 billion. PLD has excellent debt metrics as well with a Debt / Adj EBITDA of 4.0x and a Fixed Charge Coverage ratio of 11.2x.

Prologis has established an international footprint with 5,495 properties spread across 19 countries. In total, their properties cover 1.2 billion square feet. Prologis has a blended average 6-year Funds from Operations (FFO) growth rate of 12.00% and an average dividend growth rate of 12.59% since 2018.

The dividend is secure with an AFFO payout ratio of 72.31% and the current dividend yield sits at 2.51%. Prologis is one of the highest quality REITs you can own and is currently trading right in line with their average multiple with a P/FFO ratio of 24.23x. Prologis is one of just 3 stocks that receive a perfect 100/100 iREIT IQ quality rating. We rate Prologis a STRONG BUY.

American Tower

American Tower is the largest cell tower REIT, operating on a global scale with around 223,000 communication assets across 25 countries. Cell towers are a critical component to e-commerce and the infrastructure that supports it has a long runway for growth.

Since 2018 American Towers has had a blended FFO growth rate of 7.1% and this growth has enabled AMT to increase the dividend on average by 18.77% since 2018. Currently AMT has a dividend yield of 2.68% that is secure with a 2022 expected AFFO payout ratio of 58.89%.

American Tower is investment-grade rated at BBB- and as of 9/30/22 had a Net Leverage of 5.5x. They have 7.0 billion in liquidity and 77% of their debt is fixed rate. American Tower currently trades at a blended FFO multiple of 22.07x which is below their normal FFO multiple of 24.55x. Given the past earnings and dividend growth, along with the future potential to continue this growth as E-Commerce expands, at iREIT we rate American Tower a BUY.

Equinix

Equinix is a data center REIT with over 240 data centers covering 29 million square feet over 32 countries and on 6 continents. It’s the largest data center REIT with current market cap is 67.49 billion, over double that of its closest competitor Digital Realty. Equinix’s global network provides customers access to 2,100+ network services, 450+ content and digital media services, and 3,000+ cloud and IT services.

EQIX currently pays a dividend yield of 1.72% and has an average dividend growth rate of 9.19% since 2018. The dividend is very secure with a 2022 expected AFFO payout ratio of 42.38%.

EQIX has a BBB investment grade credit rating and a strong balance sheet with $6.4 billion in available liquidity, a 3.5x Net Leverage ratio, a blended borrowing rate of 1.96% with 96% of their debt at a fixed rate.

Their weighted average maturity is 8.6 years with no maturity due until 2024. Equinix has delivered strong earnings growth with an average FFO growth rate of 9.25% since 2018. Currently EQIX is trading at a blended P/FFO multiple of 24.47 which is below their normal FFO multiple of 25.32x. We rate Equinix a BUY.

Crown Castle

Crown Castle is a cell tower REIT that has a presence in every major U.S. market. They have a portfolio of infrastructure assets that consist of more than 40,000 cell towers, roughly 115,000 small cell nodes, and approximately 85,000 route miles of fiber. Their diverse mix of infrastructure assets positions CCI to deliver continued growth in earnings, dividends, and will allow them to capitalize on 5G deployment.

Since 2018, CCI has had an average FFO growth rate of 7.84% and has averaged a dividend growth rate of 8.92% over that same time period. They currently pay a dividend yield of 4.30% that is well covered with an expected AFFO payout ratio of 81.18% in 2022.

CCI has solid debt metrics with a Net Debt to EBITDA of 5.2x and a Fixed Charge Coverage of 4.9x. They have a weighted average maturity of over 8 years and 85% of their debt is fixed rate.

As of December 31, 2022, CCI had approximately $5.5 billion in liquidity available to them under their revolving credit facility. Currently CCI trades at a blended P/FFO of 19.72x which compares favorably to their normal P/FFO multiple of 22.79x. We rate Crown Castle a Buy.

Public Storage

Public Storage is a self-storage REIT and is the largest owner and operator of self-storage properties. They have roughly 2,836 facilities located in 40 states and have 1.8 million customers. In total PSA currently owns 202 million rentable square feet of self-storage properties.

Since 2018, PSA has had a blended FFO growth rate of 8.51% and currently pays a dividend yield of 2.74%. The expected AFFO payout ratio for 2022 is 155.63% which would normally be a concern, but the high payout is due to a one-time special dividend in 2022 of $13.15 per share. In 2021, PSA’s payout ratio was 69.75% which is more in line with their typical AFFO payout.

PSA has an investment-grade rating with an S&P Credit Rating of A. Their debt metrics are excellent with a Debt to EBITDA of 2.2x and a Fixed Charge Coverage ratio of 9.3x as of the third quarter in 2022. Currently, PSA trades at a blended P/FFO of 18.50x which is below their normal P/FFO of 20.29x. At iREIT we rate Public Storage a BUY.

Realty Income

Realty Income is a triple net lease REIT that specializes in single tenant free standing properties. As of the third quarter in 2022 they owned 11,733 commercial properties in all 50 states with an international presence with properties in the UK and Spain.

They are well known for paying monthly dividends and are an S&P 500 Dividend Aristocrat with 27 consecutive years of dividend increases. Currently Realty Income pays a dividend yield of 4.43% that is safe with an expected AFFO payout ratio of 76.15% in 2022.

Realty Income has an A- credit rating and a strong balance sheet with $2.5 billion in liquidity, a Net Debt to Adj. EBITDAre ratio of 5.2x and a fixed charge coverage ratio of 5.5x. They have a weighted average term to maturity of 6.3 years and 88% of their debt is fixed rate.

Currently Realty Income trades at a blended P/FFO multiple of 16.76x which is well under their average FFO multiple of 20.40x. At iREIT we rate Realty Income a BUY.

Simon Property Group

Simon Property is a REIT that specializes in Class-A Malls, Premium Outlets, International Properties, and The Mills. As of the third quarter of 2022 they owned or had an ownership interest in 230 properties covering 184 million square feet in North America, Europe, and Asia. Currently SPG has a 5.75% dividend yield that is secure with an expected AFFO payout ratio of 63.01% in 2022.

Simon has a strong balance sheet with a total of $8.6 billion in liquidity available to them as of September 30, 2022. They are investment grade rated with an S&P Credit Rating of A-. SPG has a weighted average debt maturity of 6.8 years and a weighted average interest rate of 3.30%.

Simon has a Total Debt to Total Assets ratio of 42% and a Fixed Charge Coverage of 5.0x as of the third quarter in 2022. Simon currently trades at a blended P/FFO of 10.68x which is a discount to their normal P/FFO multiple of 12.41x. At iREIT we rate Simon Property Group a BUY.

SBA Communications

SBA Communications is a cell tower REIT that owns and operates wireless communications infrastructure including towers, rooftops, distributed antenna systems, and small cells. SBAC was founded in 1989 and converted to a REIT in 2016. It has operations in sixteen markets throughout the Americas, Africa and the Philippines. To date, SBAC has a total market cap of 31.43 billion.

SBA does not have an investment grade credit rating with an S&P Credit Rating of BB+. They have a net debt to Annualized Adjusted EBITDA of 6.8x and a Net Cash Interest Coverage Ratio of 5.3x as of September 30, 2022.

They currently have a dividend yield of 0.97% and compound dividend growth rate of 56.57% since 2019. The dividend is very safe with an expected AFFO payout ratio of just 22.41% in 2022.

Currently SBAC is trading at a blended P/FFO of 23.75x which is below their normal P/FFO multiple of 26.17x. We rate SBA Communications a BUY.

Welltower

Welltower is a REIT in the healthcare sector that specializes in senior housing, post-acute care, health system, and outpatient medical centers. Welltower has 1,250 senior housing facilities, 404 outpatient centers, 205 health system properties, and 92 long-term / post-acute care facilities. They own or have an ownership interest in properties in the United States, Canada and the United Kingdom.

Welltower pays a dividend yield of 3.29% with an expected AFFO payout ratio of 85.46% in 2022. They cut the dividend in 2020 from $3.48 to $2.70 and cut the dividend again in 2021 to $2.44 per share.

As of September 30, 2022, WELL had $3.8 billion of near-term available liquidity, a Net debt to Adjusted EBITDA ratio of 6.93x and an Adjusted Fixed Charge Coverage ratio of 3.34x. They have a Weighted Avg Interest Rate of 3.85% and a Weighted Avg Maturity of 6.4 years.

Approximately 80% of their debt is fixed rate and no material senior unsecured note maturities until 2024. Currently they are trading at a blended P/FFO multiple of 22.03x, which is higher than their normal P/FFO multiple of 18.65x. We rate Welltower a Hold.

In Closing…

As you know, when you purchase shares in a large market cap weighted ETF like VNQ, you’re always going to get the good, the bad, and the ugly.

It just so happens that 8 out of 9 of the above referenced REITs are on iREIT’s buy list, but there are another 158 REITs and/or RECO’s that are included in the Index.

It’s true, that this basket of real estate stocks is passively managed with low expenses and highly diversified (broad representation of the target sector across large-, medium-, and small-cap companies).

If you prefer the ETF route, which can be hands off and provide diversification to your portfolio, VNQ can be a great low-cost option for REIT exposure.

Given that, and due to the fact that we at iREIT on Alpha are more hands-on investors, we tend to prefer individual REIT positions.

In addition, many are expecting the Fed to start tempering its stance in the first half of 2023, and with valuations looking intriguing at current levels, now may be a great time to add or increase your REIT exposure to your portfolio.

The real estate sector as a whole could provide some level of safety and in a time when the economy is slow and valuations are low, that is when you will see the best run and highly liquid REITs start to flex their muscles.

In summary, our approach is to always buy only the great, which means eliminating the good, bad and ugly.

In addition, we only want to buy the great when there’s a definitive margin of safety… and that’s the blueprint for my new smart REIT ETF Index and also happens to be the title to my book: Intelligent REIT Investor.

Happy SWAN Investing!