3 ‘Must Own’ Fortress REITs

“Free soloing is not for the faint-hearted,” HardClimbs.info informs readers.

I would add that it’s not for the intelligent, either.

I get the thrill of taking on a challenge. Believe me. I was young once too.

But I don’t think I ever considered something so – forgive me, but – stupid as climbing up mountain faces without a single strip of protective gear. Which is what free soloing is.

Both Hard Climbs and I agree that my way of thinking is the majority mindset.

For most of us, the mere thought of hanging by our fingertips on a sheer rock face with nothing but gravity waiting to greet us is enough to induce a full-blown panic attack. But for a select few, climbing without ropes is an adrenaline-pumped activity [that’s] just another day at the office. These daredevil climbers, known as free soloists, have nerves of steel, unparalleled skill, and a level of confidence that most of us can only dream of.

In my humble opinion, that’s not confidence. It’s stupidity. In which case, I’m more than happy to have lower levels of it.

But I guess to each their own.

The article goes on to detail the world’s “13 best free solo climbers,” both past and present. And some of them are most “definitely past.”

Because some of them are, tragically, deceased. They died as they lived.

May they rest in peace.

Mixed Metaphors to Prove My Fortress REIT Point

Free solo climbing is an extreme example of living on the literal edge. But most of us are or have been guilty of doing other foolish things.

Maybe not in the sense we’ll get bodily injured from the immediate impact of it. However, there are physical ramifications to losing money on “unprotected” investment ideas.

Purdue University reported the obvious in 2021 – that “the link between mental health and financial health” is significant. Moreover:

Worries about finances came in as the No. 1 stressor in the latest CreditWise survey, released in December 2020. The results indicated that finances are the No. 1 cause of stress (73%)… Financial stress was in the No. 1 spot in 2019 as well, as reflected in the 2019 Everyday Health United States of Stress survey.

High levels of financial stress, as with other stressors, can manifest itself through physical symptoms such as anxiety, headaches/migraines, compromised immune systems, digestive issues, high blood pressure, muscle tension, heart arrhythmia, depression, and a feeling of being overwhelmed.

All conditions that can lead to even worse outcomes. Yet, we put ourselves in financially stressful situations all the time!

Why?

The answer very often is that we have a short-term fixation. We’re too impatient to see immediate results, like two out of three of the fabled little pigs.

“Who’s afraid of the big bad wolf?” might sound brave at the time. But rather, like free-soloing thousands of feet into the air, it comes with consequences.

The big bad wolf might not come by to blow our straw or stick houses down this month or even this year.

But he is going to come around eventually. In which case, only those investors who built financial fortresses come out whole and happy.

Protect Yourself Property With Fortress REITs

I don’t mean to be mixing metaphors here, but I’m a safety-first kind of guy. My main goal is to help as many people as possible avoid the financial mess I found myself in 15 years ago.

If I have to commit some composition crimes in the process, so be it. It’s worth it if I get my message across.

It’s true that some people can afford to take more risks. If they’re younger, for instance, they’ll have more time to recover if riskier investments go bad. And the wealthy, of course, have more money to play with.

But even they should have at least the base of their portfolios in what I like to call “fortress” companies.

These businesses have:

• Solid balance sheets capable of withstanding even unexpected disasters
• Strong management that makes intelligent investments into sustainable products and services
• Superior positioning in their industry and the larger economic order.

I especially like fortress real estate investment trusts since they pay out dividends in the process.

These corporate landlords invest in brick-and-mortar properties – and not the kind made out of straws and sticks. Nor do they ask their investors to go out on a limb.

While there are no sure things in the stock market, fortress REITs have stellar track records. So while I can’t tell you they’ll survive anything else that could come…

A giant asteroid hitting the earth…

Godzilla rising out of the sea and stomping out buildings and businesses alike…

“That guy” getting elected (you know. The one you can’t stand, whoever that may be)…

But so far, they’ve performed very well through the thick and thin that has come. Which greatly increases the chances they won’t let investors down from here.

Prologis (PLD)

Shareholders of the industrial giant have had a rough week as the stock has fallen 13.58% in the last 5 days. The stock had been under pressure for weeks leading up to its 1Q-24 earnings announcement, and fell sharply the day earnings were released.

Even though the company beat on its top and bottom line, market sentiment soured due to below-average net absorption and its anticipated lower leasing volume in 2024. PLD attributed the low absorption to ongoing inflation and high interest rates that are keeping some customers on the sidelines.

PLD’s management team stated that the leasing slowdown is mostly felt in only a handful of markets, with Southern California and the Inland Empire being one of the most acute.

I’m not going to dig into PLD’s earnings too much since that is not the subject of this article, but suffice to say, I think the market overreacted in a major way. When PLD set its initial 2024 guidance for Core FFO to range between $5.42 and $5.56 ($5.49 midpoint) analysts were already expecting a 2% decline in FFO for the year.

During the 1Q-24 earnings release, the company revised its guidance downwards for Core FFO to range between $5.37 and $5.47, representing a midpoint of $5.42 which would be a -3.3% decline from the FFO earned in 2023.

While the revised guidance changes the 2024 FFO midpoint from $5.49 to $5.42 per share, it was no surprise that demand in 2024 would be soft due to the economic backdrop. Additionally, the company sees the current muted demand as a deferment and expects demand has just been pushed out by a few quarters.

Bottom line on the earnings front is that I believe the market’s overreaction currently presents a great opportunity to initiate a position in or add to PLD.

Today I want to focus on how to determine the “safety” of a REIT. Now, before compliance jumps on this, let me be perfectly clear that there is no investment that is completely safe.

All investments have some form of risk. Let me say that again, ALL INVESTMENTS HAVE RISK. However, there are a couple of things that we can look at to get an idea about how risky the investment may be.

A good place to start is the company’s credit rating and balance sheet. For S&P Global, anything BBB- or above is considered investment-grade. Anything BB+ or under is considered junk rated.

Of course, the higher the credit rating the “safer” the company is, all else being equal. For today’s article I went with 3 REITs that all have credit ratings of A- or above.

The Balance Sheet

When looking at a company’s balance sheet and its debt metrics, a sophisticated investor might be interested to see if the company has a cost of capital advantage, if it uses the right amount of leverage to generate optimal returns, of if the company has enough liquidity to be opportunistic during weak market conditions.

However, I think at the end of the day, most investors really want to know if the company is safe. All the other details are nice to know, but what I really need from the balance sheet is the ability to sleep well at night, knowing that the company will be around for years to come and will continue to provide a consistent stream of income.

Like all things investing, it’s not quite that straightforward, as there are several aspects to consider. For instance, a company could have the strongest balance sheet in the world, but if their business model breaks and the company is not able to generate sufficient cash flows, then nothing else will matter.

Similarly, if a company has an excellent balance sheet but is paying 95% of its cash flow to cover its dividend then that might be a red flag to consider.

While there is no single correct answer as to what amount of debt is “safe”, there are some metrics that can help us get a sense of how much debt the company has related to its earnings, its market capitalization, its total capital, its history, and its peers.

The closest thing I can give you as a rule of thumb comes from the book: Investing in REITs, 4th edition, by Ralph Block. For those of you who are not familiar with Ralph Block, think Benjamin Graham, but for REITs.

Mr. Block gives us a couple of debt metrics to consider including a debt-to-market cap ratio, a debt-to-asset value ratio (using market value), a debt-to-EBITDA ratio, and an EBITDA-to-interest expense ratio.

Assuming the stock market is at least somewhat efficient, meaning prices reflect all known facts at all known times, a company’s debt compared to its total market cap should give some indication about the degree to which a company is leveraged.

Per Mr. Block, a debt-to-market cap ratio of over 55% is concerning, while a ratio under 40% is considered conservative. Of course, this or any other debt metric should not be viewed in isolation, but rather in combination with other metrics to get a complete picture.

I, personally, take the debt-to-market cap ratio with a grain of salt considering how volatile stock prices can be. If REITs are in favor and prices are at a premium, it would understate the company’s leverage, while the opposite is true during a downturn.

A debt-to-asset ratio, using the assets’ market value rather than book, is one of the preferred ways to examine leverage by real estate professionals. However, the total market value of a company’s real estate is somewhat subjective and not accessible to most retail investors.

As a proxy, I like to use the debt-to-asset ratio using the company’s total assets as reported on its balance sheet.

This is not perfect since generally speaking the book value of a REIT’s assets will understate the true market value, but the information is readily available for all publicly traded companies and gives us some idea of how much debt a company has compared to its asset base.

Another similar metric that can be used is a company’s debt to its total capital. It is basically another way of looking at a debt to equity ratio, but I think it gives a cleaner picture of what percentage of the capital stack is financed through debt.

The debt-to-market cap ratio, the debt-to-asset ratio (market value), the debt-to-asset ratio (book value), and the debt-to-capital ratio, all give us an idea of how much debt the company has as it relates to its asset base.

I think more useful measures of a company’s financial health are its leverage and coverage ratios. Leverage ratio’s look at how much debt a company has compared to the cash it earns. The most basic form of the leverage ratio is Debt-to-EBITDA.

A coverage ratio shows how many times over a company can meet its debt obligations. The most basic form of this is the EBITDA-to-Interest Expense ratio, which shows how many times a company can pay its annual interest expense.

A more conservative measure is the fixed charge coverage ratio, which includes preferred dividend payments and scheduled debt repayments in addition to interest expense.

Per Mr. Block, a debt-to-EBITDA ratio of 5x to 7x is acceptable, anything under 4x is quite conservative, and a leverage ratio over 8x to 9x may be a cause for concern. For the interest coverage ratio, anything under 2x would be a red flag.

Prologis Business Model

Prologis is a global industrial REIT with a 1.2 billion SF portfolio made up of more than 5,000 buildings that are leased to almost 7,000 customers across 19 countries and on 4 continents.

To give perspective on its size, 2.8% of global GDP, or $2.7 trillion, is processed through PLD’s distribution centers each year. The company’s predecessor, AMB Property, got its start in 1983 and has grown to become the largest industrial REIT by market cap and square footage.

In terms of its business model, PLD owns industrial properties and leases them out to leading companies such as Amazon, Home Depot, and UPS. It collects rent checks and pays out quarterly distributions to its shareholders. Prologis has several layers on top of this including its Prologis Ventures, Prologis Essentials, and its emerging energy business, but the company’s core business is leasing industrial space.

Given the proliferation of e-commerce, which was further entrenched during the pandemic, I don’t see the demand for warehouses, flex space, and distribution centers going anywhere anytime soon. For years, the company has successfully achieved positive cash flow by leasing its properties, and there is nothing to make me think that will change anytime soon.

Below is a chart of the company’s funds from operations (“FFO”) per share from 2014, with forward estimates going up to 2028. Since 2014 the company has had a blended average FFO growth rate of 11.56%. Analysts expect 2024 FFO to fall by -2.5%, but then expect FFO to increase by 13% in 2025 and 10.3% the following year.

Some of you may be wondering why I’m using FFO instead of Adjusted FFO, and it’s because PLD reports in core FFO, which is what is listed below.

The business model has delivered success in the past and I expect that to continue. I feel very confident that PLD will continue to generate and deliver reliable cash flows to its shareholders.

Prologis AFFO Payout Ratio

While not technically a debt metric, I think the AFFO payout ratio is a critical component in determining the safety of a company. As previously mentioned, the cash flow and balance sheet could be strong, but if the AFFO payout is over 95% I’m probably not going near the stock.

Moreover, a lower or more conservative AFFO payout ratio translates into more retained earnings, which can be used to pay down debt or as a cheap source of capital for investment.

PLD’s AFFO payout ratio got a little too high for my comfort in 2014 (94.29%) but has been well within reason each year since. Since 2017 this metric has not risen above 80% and came in at 76.99% last year. PLD’s AFFO payout ratio easily covers its dividend and leaves room for growth and / or room for any potential economic downturn.

Prologis Balance Sheet

Prologis has an investment-grade balance sheet with an A credit rating from S&P Global. At the end of 2023, the company had a debt-to-market cap ratio of 20.5% and a total debt-to-capital ratio of 33.8%.

PLD had a debt to adjusted EBITDA of 4.6x and a fixed charge coverage ratio of 7.9x. Each debt metric referenced is conservative and indicates the company is not over leveraged.

~90% of PLD’s debt is fixed rate and has a weighted average interest rate of 3.0% with a weighted average term to maturity of 9.1 years. Plus, the company reported $6.0 billion of liquidity at the end of 2023. Prologis’ balance sheet is strong with plenty of liquidity and has excellent leverage and coverage ratios.

The stock pays a 3.67% dividend yield and is currently trading at a P/AFFO of 23.28x, compared to its 10-year average AFFO multiple of 27.92x.

We rate Prologis a Buy.

AvalonBay Communities (AVB)

AvalonBay is a multifamily REIT that specializes in the development, redevelopment, acquisition, and management of apartment communities located throughout New England, New York / New Jersey, the Pacific Northwest, the Mid-Atlantic, and Northern and Southern California.

In addition to its established markets, the company has been expanding into North Carolina, Florida, Texas, and Colorado. AVB targets markets that are in leading metros with growing employment, high wages, and a higher cost of homeownership.

AVB – Business Model

The company develops or acquires multifamily properties and leases the apartment homes to generate stable and dependable cash flows. As of its most recent update, the company owned or has an ownership interest in 299 multifamily communities that contain 90,669 apartments homes across 12 states and the District of Columbia.

AVB has been in the multifamily business since it went public in 1993 and has been an S&P 500 company since 2007. The company has generated positive AFFO per share growth each year since 2014 with the exception of 2020 and 2021 and increased its dividend each year between 2014 and 2020.

The company maintained its dividend at $6.36 per share in 2021 and 2022, but then increased it by 3.77% in 2023 to $6.60 per share.

AVB’s business model has been successful for the last 3 decades, and there will always be a need for shelter. It has consistently delivered positive cash flow and dividends to its shareholders and is expected to grow AFFO per share by 5% in both 2024 and 2025.

AvalonBay AFFO Payout Ratio

AvalonBay has maintained a conservative AFFO payout ratio over the last decade, with the metric averaging 72.55% over this period. There’s not much to say about the chart below other than the payout ratio spiked up in 2020 & 2021, likely due to the fall in AFFO in those years.

It is also likely that AVB did not increase its dividend in 2021 and 2022 in order to get its AFFO payout ratio back in check. This has safety written all over it. Instead of keeping its dividend growth streak intact, the company maintained its dividend for a couple of years until the dividend had more conservative levels of coverage.

Breaking its dividend growth streak may have put some investors off, but I’d personally rather the company shore up its financials than keep the streak alive.

AvalonBay Balance Sheet

AVB has an investment-grade balance sheet with a credit rating of A- from S&P Global. The company has excellent debt metrics including a net debt to core EBITDAre of 4.2x, a long-term debt to capital ratio of 39.21%, and an interest coverage ratio of 7.7x.

95% of its net operating income (“NOI”) is unencumbered, its debt has a W.A. term to maturity of 7.7 years, and the company had excess liquidity after open commitments of $1.4 billion as of the end of 2023.

At the end of 2023, the company had $20.7 billion in total assets and $8.1 billion in total debt, for a debt to asset ratio of ~39.3%. This is based on book value. Based on market capitalization, the company has $8.1 billion in debt and a market cap of $26.08 billion, for a debt-to-market cap ratio of ~31.2%.

As you can see from the chart below, AVB has consistently maintained a conservative capital structure over the past decade.

AVB has a solid business model that has delivered consistent and growing cash flows for nearly 3 decades. It consistently pays out a conservative amount of its earnings and has a strong balance sheet with plenty of liquidity.

The stock pays a 3.74% dividend yield and trades at a P/AFFO of 19.04x, compared to its 10-year average AFFO multiple of 22.63x.

We rate AvalonBay a Buy.

Camden Property Trust (CPT)

Camden Property is a multifamily REIT that specializes in the acquisition, development, and management of multifamily apartment communities. The company was formed in 1993 and is based in Houston, TX. Unlike the apartment REIT we just looked at, CPT’s properties are primarily located in the Sunbelt region of the country.

CPT – Business Model

Camden’s portfolio is made up of 172 operating communities that contain 58,634 apartment homes with an average age of 15 years and an average occupancy of 95%.

Additionally, the company has 4 multifamily communities in development which are expected to include 1,166 apartment homes upon completion.

A big part of CPT’s investment strategy is its strong focus on Sunbelt markets. The company has properties outside of the Sunbelt, for example Washington, D.C., but the vast majority of its properties are located in the Sunbelt.

The company’s largest market is Washington, D.C. at 12.8% of its NOI, followed by Houston at 12.7% and Dallas at 8.2%. CPT has a particularly large presence in Texas and Florida, which combined make up 45.5% of its NOI.

Another component of its investment strategy is to generate consistent earnings growth through its operations, acquisitions, and developments and to attract a wide array of potential tenants through a diversified portfolio. The company has a diversified mix of properties that vary by class, market, and building type.

62% of its portfolio is made up of Class B properties and 38% consists of Class A properties. This offers a mix of price points to attract a range of tenants. Along the same lines, the portfolio is diversified by location, with 42% in urban locations while 58% are in suburban locations.

Finally, the apartment REIT has a variety of building types including low-rise, mid-rise, high-rise, and mixed. Almost 60% of its properties are low-rise communities, 28% are mid-rise, 9% are high-rise, while 4% are mixed properties.

Camden Property has successfully constructed, acquired, and managed multifamily communities for over 30 years and has paid a dividend to its shareholders each year since its formation in 1993.

Over the last decade, CPT has delivered an average AFFO growth rate of 4.96% and an average dividend growth rate of 4.79%. I removed the special dividend paid in 2016 from the chart below to normalize its growth.

Camden Property AFFO Payout Ratio

CPT has also maintained a very conservative AFFO payout ratio since 2014 with an average payout ratio of 73.57 over the last decade. The metric exceeded 80% only once, and came in at 67.34% last year. This low and conservative payout ratio should insulate the dividend from any potential downturn and provide room for growth in the years ahead.

Camden Property Balance Sheet

CPT has an investment-grade balance sheet with a credit rating of A- from S&P Global and A3 from Moody’s. As of its most recent update, 90.7% of the company’s debt is unsecured and 84.8% is fixed rate. The company has excellent debt metrics including a net debt to adjusted EBITDAre of 4.1x, a long-term debt to capital ratio of 36.60%, and an EBITDA to interest expense ratio of 6.77x.

The company’s debt has a weighted average interest rate of 4.2% and an average term to maturity of 6.7 years, plus it has $78.0 million of cash and $1.2 billion of availability under its credit facility.

For 30 years, Camden Property has successfully operated in the multifamily space and I believe they will continue to do so for the foreseeable future. Analysts expect AFFO to fall by -2% in 2024, but then project it to increase by 3% in 2025 and then by 6% the following year.

The stock pays a 4.32% dividend yield and trades at a P/AFFO of 16.14x, compared to its 10-year average AFFO multiple of 21.43x.

We rate Camden Property Trust a Strong Buy.

In Closing

Warren Buffett has been referring to this “wide moat” analogy for decades.

What does the “moat” analogy mean?

In order to be successful, a business must have a definite moat, AKA a competitive advantage that allows it to maintain pricing power and consistent profit margins.

One of these important advantages is the balance sheet, which is a reason that our team spends countless hours finding businesses “with a wide and long-lasting moat around it, protecting a terrific economic castle with an honest lord in charge of the castle” (- Buffett).

As always, thank you for reading and commenting.