This “High Alpha” REIT Is Poised To Profit
Much of the power of the margin of safety concept lies in its wide applicability. As Benjamin Graham explained,the margin of safety constitutes a “favorable difference between price on the one hand and indicated or appraised value on the other.”
It’s something of an “all purpose” risk minimization tool with which one can proceed with a fair degree of certainty that, regardless of day-to-day price fluctuations, one’s principal is likely to be secure. Quite simply, the wider the margin of safety, the lower the risk and the greater potential for gain.
When I select REITs for the High Alpha REIT portfolio I am essentially looking for companies that have the widest margin of safety, and that I believe have the best possibility for outsized share price appreciation. Sir John Templeton sums up the margin of safety as follows,
“To buy when others are despondently selling and sell when others are greedily buying requires the greatest fortitude and pays the greatest ultimate rewards.”
Today I am providing you with a classic value pick and one in which I believe has a strong margin of safety that constitutes a “favorable difference between price on the one hand and indicated or appraised value on the other.”
Last week I explained that “I am initiating a new High Alpha REIT Portfolio and I intend to include CBL Properties (CBL) in it. Although I would not recommend CBL for “the average Joe” or “my mother,” I believe that there are excellent opportunities today for certain non risk-averse investors who are willing to stomach the risks. I will provide disclaimers whenever I recommend a HIGH ALPHA REIT so that there is no confusion over my standard REIT recommendations.”
Let’s get started with another of my High Alpha REIT picks….
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Investors Real Estate Trust: 50-Years Old and Counting
Investors Real Estate Trust (IRET) is a self-advised equity REIT that was organized under the laws of North Dakota. Since formation in 1970, the business has consisted of owning and operating various income-producing real estate properties.IREIT listed on NASDAQ in1997 and transferred to NYSE in 2012.
The company was previously a diversified REIT; however, the company’s goal is to become a 100% pure play multifamily REIT; proceeds of non-core asset sales are being re-deployed into multifamily assets and other capital allocation strategies. IRET has gone from 30% multifamily to over 70%:
IRET’s narrower focus on multifamily properties requires greater specialization from IRET leadership, as a result, the company has made recent additions to the board and management team. As you can see below, the management team brings deep knowledge into the multifamily sector.
IRET’s leadership team is fully committed to growing and transforming the company to be a recognized best-in-class apartment owner and operator. The leadership team expects to improve IRET’s portfolio by enhancing its operations, adding quality assets, ad strengthening its financial position.
Note: I have known Mark Decker, IRET’s CEO, for a number of years and I consider his experience a critical reason for my BUY recommendation. Decker was appointed President and CEO of IRET in April 2017. Previously, he served as CIO of IRET when he joined the company in August 2016. Prior to that, he served as Managing Director and US Group Head of Real Estate Investment & Corporate Banking at BMO Capital Markets, where he helped grow the platform into an active participant in real estate debt, equity and M&A transactions. He worked for nearly 16 years as a real estate investment banker at BMO Capital Markets, Robert W. Baird & Co. and Ferris, Baker Watts and during that time, was involved in more than $90 billion in real estate capital markets and advisory transactions. Prior to that, Decker started his career in banking in Friedman, Billings, Ramsey & Co., Inc.'s Financial Institutions Group.
Also John Kirchmann was appointed CFO in April 2017. Previously, he served as Vice President of Operations Support at Essex Property Trust (ESS) until July 2016 where he was responsible for the oversight of revenue management and ancillary income, procurement, and other functions. From 2007 to 2011, he served as Corporate Controller & Corporate Treasurer at ESS, where he oversaw property and corporate accounting functions, treasury management, and re-engineered and implemented new technology and systems. Kirchmann started his career at KPMG.
As illustrated below, the goal is to become a 100% pure play Upper Midwest-focused multifamily REIT:
The Transformation, Almost Complete
Over the past three years IET has made monumental progress to transform the company, by investing (through acquisition or development) more than $607 million in newer or brand new high quality apartment communities.
IRET sold more than $756 million of non-core commercial and senior housing properties, and achieved good execution and pricing, utilizing proceeds to fund new investments and significantly de-lever the company. As former CEO Tim Mihalick referenced on the previous earnings call,
“Long-term, we believe these efforts to focus our Company on multifamily will have significant benefits, including greater operating efficiency, simplified management and strong earnings and NAV growth. There is still work to be done, but our team is energized as we move forward with our goal to drive long-term growth and create value for our shareholders.”
In regard to acquisitions IRET continues to target newer higher quality apartment communities in the larger Midwestern MSA's. Markets remain competitive for these type of assets and IRET is looking for situations that offer components to provide a more attractive stabilized return. As Mark Decker explained on the recent earnings call,
“We have a number of assets under review, leveraging our relationships with developers and private real-estate owners in our markets to find the best available opportunities. “
Similar to NexPoint Residential Trust (NXRT) – see my recent ARTICLE – and Preferred Apartment Communities (APTS) – see my recent article HERE – IRET focuses on secondary markets with a shift towards newer and higher valued apartment communities. Here’s a snapshot comparing IRET’s market capitalization with the peer group:
The Balance Sheet
IRET is a small-cap REIT so the company is not going to attract investment grade ratings any time soon; however, the company has reduced liabilities and reduced leverage metrics. Long term, IRET's goal is to achieve credit rating metrics in line with the peer group with an investment grade rating.
During the fiscal third quarter, IRET sold five senior housing properties and one retail property for a total of $74 million. The company used the proceeds to redeem all of the outstanding Series A 8.25 preferred stock for $29 million, and repaid $13.5 million of debt with the weighted average interest cost of 3.5%.
Subsequent to quarter end, IRET sold 18 senior housing properties and one medical office building for $136 million, and utilized proceeds to repay $21 million of outstanding debt at a weighted average interest rate of 5%. In addition, subsequent to quarter end, the company applied $91 million to the new line of credit to lower interest costs and decrease availability.
The importance of these efforts was demonstrated with IRET’s new expanded and unsecured credit facility. The new $250 million facility has a four-year initial term and one-year extension option, and $250 million accordion feature, which provides the company with the lower cost and more flexible capital source.
Today IRET has meaningful liquidity and lower leverage, which at quarter end, stood at 7.1x net debt to adjusted EBITDA. As Mark Decker explained,
“IRET has never had more firepower and we are confident that with our reinvigorated focus on disciplined in capital allocation, we will successfully grow the quality and size of our cash flows through targeted acquisitions at the best price possible.”
Now Let’s Get Down “High Alpha”
Up until now you are probably asking yourself, why am I writing about IRET, a small cap REIT that recently cut its dividend?
I’ll discuss the dividend below, but first let me tell you what gets me excited….
As you may recall, I recently wrote an articleexplaining Healthcare Trust of America’s (HTA) acquisition of all of the medical office building (or MOB) assets and medical development platforms of Duke Realty (DRE) for $2.75B in cash. As HTA’s CEO, Scott Peters explained,
“This transaction solidifies HTA as the dominant owner and operator of medical office buildings located in key, gateway markets in the U.S.”
HTA will soon become the largest owner of MOBs in the U.S. (larger than VTR) with a combined portfolio of approximately 24.9 million square feet of gross leasable area (Pro forma enterprise value of approximately $9.4 billion). The DRE MOB portfolio consists of 71 high-quality MOB buildings and 7 development properties or expansion projects totaling 6.6 million square feet.
The cap rate on the DRE MOB deal is sub 5% (this includes development deals that are ~86% pre-leased) and the yield on cost is closer to 5.25% when the development is stabilized. The MOB portfolio is fairly new (~8 years old) and this means it has low cap ex near-term. I am confident that many other REITs pursued the deal, most likely Physicians Realty (DOC) and Ventas, Inc. (VTR).
What’s the point?
As noted, IRET has one last deal to do before the company becomes a “pure play” apartment REIT and that is to liquidate the MOB portfolio.
IRET’s MOB portfolio includes 30 properties; all high quality and the majority of which are on-campus, which will surely attract significant investor interest and HTA has SET THE BAR! Take a look at this intel (provided in IRET’s recent investor presentation):
Based on my best guess (assumption), the DRE MOB portfolio traded at ~$450 per square foot and while IRET’s MOB portfolio is more concentrated (90% MN-focused), the sub 5% cap rate (paid by HTA) provides some valuable clues.
IRET’s MOB portfolio generates approximately $27 million of NOI (23% of NOI) and applying a 5.4% cap rate, the valuation is $500 million (mid-point of sales/SF estimate). Subtracting at ~$100 million of debt, the NAV for IRET’s MOB portfolio is ~$400 million, or $3.05 per share.
Maybe that’s too aggressive, assume that I use the low-end of IRET’s sales/SF comparison ($450 million), and after deducting $100 million, I come up with $2.67/share.
IREIT closed today at $6.16 per share, and based on my estimates, the MOB portfolio could fetch around $3.00 per share (or 23% of the NOI).
IRET’s management team should move on this ASAP!
As I said, HTA has “set the bar” with the DRE MOB portfolio and Congress could put the brakes on the 1031 exchange laws, preventing IRET from using the like-kind swap regulations. Simply said, “it’s time to make hay while the sun is shining.”
Examine the Margin of Safety
In the latest quarter (fiscal third quarter) IRET’s FFO was $12.7 million or $0.09 per share as compared to $54.5 million or $0.40 per share for the same period of the prior year. Adjusting for the impact of one-time gains and losses related to the debt repayments, FFO would have been $0.12 per share in the fiscal third quarter of 2017 compared to $0.14 per share in the fiscal third quarter of 2016.
FFO for the nine-month period ending January 31, 2017 was $45 million or $0.33 per share as compared to $84.7 million or $0.61 per share for the same period of the prior year. Adjusting for the impact of one-time gains and losses related to debt repayments, FFO per share would have been $0.35 per share for the nine-month period, ending January 31st compared to $0.44 per share in the prior year to-date period.
Also IRET reduced and tightened its guidance range to $0.41 to $0.43 per share from the previous guidance of $0.48 to $0.52 per share, which is an $0.08 adjustment at the midpoint. The drivers of this change were, first, a $0.04 reduction from lower than expected multifamily portfolio operating results, partially offset by a reduction in expected G&A.Second, a $0.04 reduction due to prepayment penalties, and the write off of unamortized fees related to the redemption of the Series A preferred stock, partially offset by lower interest costs.
As you can see, IRET has seen a steady decline in FFO, and more recently the company cut its dividend. In a recent article I explained,“the dividend cut is a "done deal" as IRET “wanted a CapEx policy which is related to AFFO that is more consistent with the peers.
I have been covering IRET since August 2013 and here are my recommendations:
Let’s examine IRET’s dividend yield:
Now let’s examine IRET’s P/FFO multiple:
Cutting to the Chase: IRET has new management, focused on putting shareholders first. Unlike APTS that has become a more complicated story (diversified portfolio with significant non-traded preferred shares) or NXRT (an externally-managed REIT), IRET has one circle of competence, or it will soon…
IRET’s MOB portfolio has significant value – around 50% of NAV – and there should be a number of public and/or private suitors circling the wagons. There MOB catalyst is real and I have confidence in Mark Decker and his team, and there is little doubt that, as a law of nature, IRET will soon resume the due course and deliver investors (including me now) “high alpha”.
DISCLAIMER: I recommend a HIGH ALPHA REIT so that there is no confusion over my standard REIT recommendations. Subscribe to my marketplace content HERE.
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Brad Thomas is a Wall Street writer, and that means he is not always right with his predictions or recommendations. That also applies to his grammar. Please excuse any typos, and be assured that he will do his best to correct any errors,if they are overlooked.
Finally, this article is free, and the sole purpose for writing it is to assist with research, while also providing a forum for second-level thinking. If you have not followed him, please take five seconds and click his name above (top of the page).
Sources: FAST Graph and IRET Investor Presentation(s)
REITs mentioned: (BRG), (AIV), (ESS), (MAA), (UDR), (CPT), (EQR), (AVB), (MORE), (APTS), (IRT), and (NXRT).
Disclosure: I am on the Advisory Board of NY Residential REIT, and I am also a shareholder and publisher on the Maven.
APTS, ARI, BRX, BXMT, CCI, CCP, CHCT, CLDT, CONE, CORR, CUBE, DLR, DOC, EXR, FPI, GMRE, GPT, HASI, HTA, IRET, IRM, JCAP, KIM, LADR, LTC, LXP, NXRT, O, OHI, PEB, PEI, PK, QTS, ROIC, SKT, SNR, SPG, STAG, STOR, STWD, TCO, VER, VTR, WPC