Let’s go straight to the point:
The bad news is that with inflation remaining stubbornly high, the Federal Reserve could get more aggressive with its rate hike campaign.
Earlier this month, there was some hope that central banks would slow down their pace of interest rate hikes to protect the economy, but these hopes are now slowly disappearing.
Rates are almost certainly headed higher, at least in the US, and given how the market has reacted to it so far, there are good reasons for concerns. This is especially true for real estate investment trusts, or REITs (VNQ), which are down heavily over the past few weeks:
But there’s also good news about this.
The good news that most REIT investors seem to forget about is that REITs actually benefit from inflation.
With inflation remaining stubbornly high, we can expect REITs to continue growing their cash flow at a rapid pace. Higher inflation leads to:
- Higher construction costs
- Less competition from new properties
- Rising replacement values of existing properties
- Lower ownership affordability
- A larger pool of renters
- And ultimately, higher rents!
This explains why most REITs have hiked their dividend in 2022 and only a handful had to cut them. Not just that, many of the dividend hikes were very substantial:
As an example, EastGroup Properties, Inc. (EGP) hiked its dividend by 13.6% in 2022. SEGRO Plc (OTCPK:SEGXF) also hiked it by 9%.
Even then, the market only sees the bad news and ignores the good news.
Investors are hyper-focused on rising interest rates as if it was the only thing that mattered, but forget that interest rates are only rising because of inflation, which is actually beneficial for REITs.
What investors should really ask themselves is the following:
Which has the greatest impact on the performance of REITs: rising interest rates or inflation?
Rising rates lead to higher costs.
High inflation leads to higher income.
What’s the net impact? Is it positive or negative?
The market clearly believes that it is negative and this is why REITs are down so heavily. But contrary to what the market is telling us, we actually think that the net impact is positive in some cases, and while it might be negative in some cases, the impact is not substantial.
Take the example of EastGroup Properties, a REIT that specializes in urban, in-fill industrial properties in rapidly growing sunbelt markets. It dropped by 35% in 2022, which suggests that its business was facing a severe crisis, but is it really?
Its funds from operations, or FFO, per share rose by 15% in 2022 because its rents are rising rapidly. As leases expire, it is possible to sign new ones with 20-30% rent bumps.
Its rents are rising so rapidly in large part because of inflation. The higher construction costs, labor costs, and interest rates have made it a lot more expensive to build new industrial properties. It only makes sense to build new properties if you can charge materially higher rents.
And since there is a lack of such industrial properties, tenants simply have no other option. They have to accept the higher rents or move out because there is a long line of other tenants who want to rent space.
In other words, the growing demand has not been met with enough new supply, partly because of inflation, and as a result, EGP now has a near-100% occupancy rate and its rents are rising the fastest in many years.
Its share price tells you that its business is doing poorly, but in reality, its growth has actually accelerated in 2022.
The impact of inflation has been very positive, and the impact of rising interest rates has not been significant since EGP uses little debt and has long maturities. It only has a 20% LTV and no major maturities until 2026. It could literally pay off its debt maturities with retained cash flow if it wanted to.
Actually, you could even argue that the higher interest rates benefit EGP because it makes ownership a more expensive alternative to its tenants and therefore, increases EGP’s bargaining power, allowing it to hike its rents even more than it could otherwise.
Is the market to correctly price EGP at a 35% lower share price?
We don’t think so.
We think that the market overreacted to the perceived “bad news” of rising interest rates, and failed to recognize that the bad news actually hides some very “good news.”
As a result, EGP has now become deeply discounted, trading at a 35% discount to NAV, which is one of its lowest valuations ever.
You may think that EGP is an exception, but it really isn’t.
The recent market sell-off took down every single REIT, regardless of what they own and how leveraged they are.
Some of them of course deserve to trade lower, but many do not, and that’s what we are targeting at High Yield Landlord. We are looking for those REITs like EGP that have been unfairly beaten down and now offer great value for money. We expect them to quickly recover once the market recognizes its mistake.
Editor’s Note: This article discusses one or more securities that do not trade on a major US exchange. Please be aware of the risks associated with these stocks.