REIT (VNQ) recovered after the announcement that the consumer price index had returned to the target range.
The market took this as further evidence that the Fed’s aggressive rate-hiking cycle had finally killed inflation and that further rate increases would not be necessary.
On the contrary, many investors quickly changed their minds and now expect short-term rate cuts.
Morgan Stanley just released its 2024 outlook and predicts that the Fed will make significant interest rate cuts over the next two years as inflation cools. They expect the Fed to begin cutting rates in June, and then again at each meeting from then on, in increments of 25 basis points. They expect the policy rate to rise to just 2.375% by the end of 2025.
UBS expects even steeper rate cuts. Very recently, they said CNBC expects the Fed to cut interest rates by up to 275 basis points in 2024 as the world’s largest economy slides into a recession.
And it’s not just Morgan Stanley and UBS.
In fact, this is starting to become a consensus expectation.
It’s funny how quickly things can change. Just a few months ago, everyone was talking about a “higher for longer” environment, and REITs were collapsing.
Today, people are realizing that the inflation may have been temporary and that those high interest rates may not be sustainable after all.
As a result, REITs now appear to have started their recovery:
But not all REITs participated in this recent rally, and some of them remain very opportunistic.
Here are two examples that we are accumulating at the moment:
BSR REIT (HOM.U / BSRTF)
I believe this is because, although it only invests in the United States, BSR is actually structured in Canada and that is where it is primarily traded.
As a result, its stock often breaks out of its peer group in the short term, and we think this is an opportunity for us to buy more shares before the market recognizes this anomaly.
Today, it’s still priced at an implied cap rate near 7%, which is truly exceptional for a portfolio of Class B Texas garden-style apartment communities. You’d be happy to get a cap rate of 5% on the private market for these assets.
On a unit price basis, we also only pay about $170,000, but the cost to replace these properties would be about 50% higher.
We expect its net asset value per share to stabilize around $18 per share, which means we are at a 35% discount.
Management is in the process of buying back shares to create value and I am happy to buy back some as well. Who doesn’t want to buy apartment communities in the rapidly growing Texas markets at 65 cents on the dollar?
Not long ago, BSR was trading at a slight premium to its net asset value. Its price was 110 cents on the dollar before the interest rate hike.
While I can’t predict when BSR will close the gap to its NAV, I believe it will happen over time and could unlock up to 60% upside potential.
Also keep in mind that I’m using $18 per share as my NAV and that estimate has already been reduced quite significantly. It was around $23 at its peak and rents have risen further since then.
Finally, pending the long-term rise, the dividend yield is almost 5%, despite retaining almost half of its cash flow for value-generating share repurchases.
NewLake Capital Partners (OTCQX:NLCP):
But something curious happened at the recent rally. IIPR massively outperformed NLCP:
We think it has nothing to do with fundamentals.
This is simply because NLCP is not listed on a major exchange and therefore market reactions are often delayed by lower capital flows.
But from a fundamental perspective, the NLCP is actually superior to the IIPR in many ways:
- It has no debt and significant net cash.
- It only owns properties in limited license states.
- Its small size should allow it to grow more quickly.
- It is trading at a lower valuation.
- It offers a significantly higher dividend yield.
- Management buys back shares.
So relatively speaking, the NLCP today remains very opportunistic compared to the IIPR.
Currently, its shares cost just 8x FFO and offer a 10% dividend yield, which still leaves enough cash flow for the company to buy back shares. This is particularly attractive given that the company has no debt and benefits from above-average annual rent increases thanks to its long-term triple net leases.
I think the shares could easily be repriced to 12x FFO, which would result in up to a 50% upside from the current stock price. A fall in interest rates would be a powerful catalyst.
Opportunities remain abundant in the REIT sector, but the window of opportunity is closing. Now is the time to buy REITs before interest rates return to lower levels.
Editor’s Note: This article discusses one or more securities that are not traded on a major U.S. exchange. Please be aware of the risks associated with these actions.