Investing In Real Estate Stocks In The War Against Inflation
On a national scale, housing affordability weakened in May as monthly mortgage payments jumped to 5.31% versus the same time last year at 3.01%. The housing affordability index illustrates a decline, although the real estate market remains robust.
Although there’s been some flattening due to higher rates and fears of a recession, these headwinds could bring the supply and demand back in alignment following months of frenzied home-buying post-pandemic and a seller's market riddled with bidding wars.
According to the Labor Department, inflation in June reached 9.1% in the U.S., its height in 41 years, with food, fuel, and shelter as the most significant contributors. The rent index increased 0.8% over the month, which was the largest monthly increase since 1986. And while the data indicates a softening in the real estate market,
“We don't have the credit issues that plagued us last time. Homeowners are financially better off than they were in the lead-up to the 2008 financial crisis. This time around, we also don't have widespread subprime mortgages. Also, if nationwide home prices do begin to plummet, the Fed could always ease up on mortgage rates,” said Moody’s Analytics Chief Economist, Mark Zandi.
Real estate investments have typically served as a hedge against inflation over the long term. As alternative investments, real estate stocks offer dividend benefits and portfolio diversification, with REITs blending an array of income-producing offerings and long-term total returns similar to stocks. As I wrote in 3 Best REITs to Buy to Fight Inflation,
“REITs are publicly traded companies that allow investors to buy shares of trending real estate portfolios for a profit or hedge against market volatility. They are liquid with attractive return potential in low and high-inflation environments and trade on major stock exchanges.”
Within the alternative space, according to a Visual Capitalist that uses Federal Reserve data, REITs have the lowest risk as a measured asset class, using standard deviation, which looks at the amount of variation in returns. According to a 40-year analysis performed by NAREIT, REITs performed well in both high and low inflation periods.
“In 2021, considered a high inflation year (7.0% or greater), REITs outperformed the S&P 500 by 12.6 percentage points with an annual return of 41.3% compared to 28.7% for the S&P 500. REITs tend to outperform in the high inflation periods, with strong income returns offsetting falling REIT prices. On average, REITs outperformed the S&P 500 by 5.6 percentage points during these periods. In periods of moderate inflation (between 2.5% and 7.0%), REIT dividends more than compensated for the higher price returns on the S&P, leading total returns on REITs to exceed the S&P by 3.1 percentage points. In periods of low inflation (under 2.5%), REIT returns fall below the S&P 500 as the income portion does not make up for superior price returns on the S&P 500” -Nicole Funari, VP NAREIT Research.
One of the biggest drivers of investor inflows into REITs is inflation. Investors want to generate income and boost their risk-return profiles, especially when so many have experienced losses in this down market.
Investing in high-quality companies that are undervalued and deliver attractive returns is the name of the game. And while it may seem counterintuitive to invest in real estate when sales are softening amid rate peaks, this third-largest asset class is perfect for investment when people are looking to fight inflation, which is why I have two strong buys, top-ranked REITs to invest in.
2 Top REIT Stocks To Invest In
Investors' initial reaction during a rising interest rate environment is to sell out of interest rate-sensitive stocks like utilities and REITs, which we’ve already witnessed in YTD REIT performance. First Trust FTSE (FFR), which mirrors the NAREIT Global Real Estate Index, has seen a decline of nearly 22%.
FFR/NAREIT Global Real Estate Index ETF 1yr Performance
However, over the long term, REITs can benefit investors because they are excellent portfolio diversifiers. The real estate sector has been a solid indicator for predicting recessions or economic rallies in the past. Real estate offers competitive returns and long-term capital appreciation, similar to value stocks, making companies in this sector attractive buys.
Although there may still be some downside as the Fed continues to raise rates, given that long-term rates appear restrained, for now, we could be at an attractive inflection point for REITS, assuming you're willing to accept some further volatility over the short-term. If so, here are two of my top REITs, according to the quant ratings.
1. EPR Properties (NYSE:EPR)
- Market Capitalization: $3.61B
- Dividend Yield (FWD): 6.86%
- P/AFFO (FWD): 10.62
- Quant Rating: Strong Buy
Leading experiential net lease REIT where customers can eat, play, and just have fun, EPR Properties’ (EPR) commercial portfolio includes movie theaters and companies like Top Golf, Margaritaville properties; leading ski resort destinations like Vail Resorts; and amusement parks to name a few. With significant liquidity for expansion and a near 7% forward dividend, EPR offers excellent fundamentals for the income-focused value investor.
EPR Valuation & Momentum
Possessing an A- valuation grade, EPR comes at a steal. Trading under $50 per share and below its mid-52-week range, EPR has an EV/EBITDA (TTM) of 14.36x, -27.63% difference to its peers, and trailing P/AFFO of 12.33x outperforming the sector by 28%, this REIT is undervalued.
Although the stock has experienced a decline over the last year along with most of the market, EPR has rebounded nicely and is on an uptrend, +4% within the last month. In addition to a strong valuation, EPR’s quarterly price performance continues to outperform sector peers, as showcased in the Momentum Grades.
EPR Growth & Profitability
Almost entirely rebounded from the pandemic’s destruction, EPR’s financials, profitability, and analyst revisions are in good shape. EPR’s liquidity and exposure to varying types of real estate in one investment highlight its unique opportunity and that of the diverse holdings within REITs. Not only does EPR have a solid dividend yield, but it has also paid a dividend for many years, recently declaring a $0.275 dividend.
EPR’s stock rose following Q1 earnings report that showcased the company’s FFO per common share of $1.10 beat by $0.07, boosting guidance. Year-over-year revenue of $157.47M rose by 40.90%, and with continued momentum and growing demand for out-of-home leisure activities, EPR is positioned to capitalize. Solid cash from operations and stellar year-over-year operating cash flow growth is more than 3,000% above its sector peers.
“In 2022, we are uniquely well positioned to execute on a defined set of opportunities armed with a strong balance sheet. We are confident in the acceleration of our investments spinning based upon the substantial progress we have made on a number of transactions that we expect to close in the second half of the year. We are reaffirming our investment guidance, noting that this year's deployment will have most of its impact on next year's earnings. As we consider the strength of our portfolio performance results to date and expectations for the remainder of the year, we are pleased to be raising our earnings guidance for the year” - Greg Silvers, EPR President & CEO.
After regaining post-pandemic momentum in times when people need to have fun while making money, EPR offers the perfect mix of value and tremendous fundamentals in a REIT that performs well in high and lower inflationary environments, according to history. EPR continues to see positive trends and growth among its customer groups, which should translate into more customers and revenue, which is why this stock is rated a strong buy.
2. W. P. Carey Inc. (NYSE:WPC)
- Market Capitalization: $15.87B
- Dividend Yield (FWD): 5.13%
- P/AFFO (FWD): 15.93
- Quant Rating: Strong Buy
Currently ranked #1 in its sector and industry and one of the largest net lease REITs in the U.S. and Europe, W. P. Carey Inc. (WPC) is a diversified REIT focused on mission-critical assets like warehouses used for the essential operations of its tenants, and high-quality, single-tenant properties. WPC has been very successful through rent escalations and rising real estate values, especially in this environment. Owning more than 1,336 properties with 356 tenants and a 98.5% occupancy rate, 99% of its leases have rent escalations.
U.S. mortgage rents are topping $2,000 for the first time. Commercial real estate is also a benefactor of the rising rate environment, despite the concerns from developers and operators about the cost of capital and bank financing rates, which could prompt an increase in private credit offerings and non-bank lending.
WPC Growth & Profitability
WPC’s diverse tenant holdings and geographic locations should benefit from the rising rate environment, given the benefits of diversification and varying rent escalation structures. Not only has WPC beat earnings for several quarters, its recent Q1 adjusted FFO per share of $1.35 beats by $0.11, and revenue of $348.44M beat by $7.48M.
"In an environment where cap rates have recently started to move higher, albeit lagging the swiftness of interest rates, we continue to see strong deal momentum with an active, growing pipeline — at average expected yields sufficiently above of our cost of capital," said CEO Jason Fox.
With inflation expected to persist and WPC’s track record of increasing rents, leases that include CPI-linked rent increases experience scheduled rent adjustments quarterly, with the average for Q3 2021 receiving a 3.3% bump. Tenants who did not receive increases for that period are scheduled for an increase over the next nine months. With more than 99% of WPC’s net leases having built-in rent increases, 58% are linked to inflation.
“So there's a real tailwind that we have flowing through to our portfolio. There is a bit of a lag effect on how inflation flows through. Typically, the way that the formulas work in a lease is there's a look back. You do a look back three months and take an average of that three-month period and compare it to the three-month period from the year prior…how it flows through to our leases has lagged a little bit from the start, but that also means that it's going to linger longer on the back end if inflation starts to moderate over the coming quarter or next year,” Jason Fox at Nareit REIT Week.
Overall, Fox anticipates a 3% to 3.5% hike in rents but could go as high as 4% in 2023. With a strong focus on industrial and logistics assets, more than $2B in new property acquisitions, and a real estate AFFO increase of $252.0M from Q4 2021 of $239.0M, WPC is well positioned to capitalize in the current and future environment. In addition to ranking as one of our top-rated diversified REITs, WPC raised its quarterly dividend to $1.057/share in May, indicating its strength and commitment to shareholders. Not only does the company’s balance sheet look great, but the company also comes at a relative discount with stellar momentum.
WPC Valuation & Momentum
WPC has a B- valuation rating. With a trailing P/AFFO of 15.94x, a -7.25% difference to the sector, we believe WPC is trading at a discount with ample room for continued growth. Over the last five years, WPC’s share price has been on an upward trend, +22% and despite declines in REITs over the last year, WPC is still positive 1% YTD. As evidenced by the A+ momentum grade below, the stock performs well with gradual increases quarterly, outperforming its sector peers.
Given WPC’s strong characteristics and discounted price, we believe WPC will continue to be a strong buy into the future, along with our next REIT.
Consider Our Best REITs for 2022 As Inflation Hedges
Despite economic uncertainty, real estate, mainly REITs, have historically served as an inflationary hedge, and there are economic indicators that the future of real estate should remain strong. REITs like my picks EPR and WPC can offer solid returns over long periods amid rising interest rates and offer income, especially in the current environment. Year-to-date, both REIT stock prices have been steady and virtually unchanged. Considering the S&P 500 is down 20%, flat performance from the REITs plus the dividend yield makes these two REITs look very attractive. Both stocks come at a discount and benefit from increasing rent rates and pricing competition. With strong dividend yields and growth and profitability prospects, EPR (a specialized REIT) and WPC (a diversified REIT) come at reasonable price points and possess excellent fundamentals and bullish momentum.
Seeking Alpha’s REIT screens help ensure you are furnished with the best resources and data to make informed investment decisions. The screens rank the REITs by scoring the relevant financial metrics on a sector-relative basis. We have many Top REITs for you to choose from in different sub-sectors, which can be identified in our Top Real Estate Stocks screen.