3 Top REITs That Are Exceptionally Cheap Right Now

REITs have been hit especially hard in the ongoing bear market. While the S&P 500 has declined 18% this year, the Real Estate Select Sector SPDR ETF (XLRE) has shed 26%.

The main reason behind the underperformance of REITs is the impact of high interest rates on the interest expense of most REITs, which carry appreciable amounts of debt.

However, some REITs have become extremely cheap from a long-term point of view. As soon as the headwind from high interest rates begins to subside, those REITs with strong fundamentals are likely to highly reward their unitholders.

With that said, let’s discuss the prospects of three exceptionally attractive REITs.

A Pure-Play Hospital REIT

Founded in 2003, Medical Properties Trust (MPW) is the only pure-play hospital REIT in its sector.

The REIT owns more than 400 properties which are leased to more than 30 different operators. Most of the assets are general acute care hospitals and are well diversified across different geographies, with properties in 29 states, to mitigate the risk of demand and supply imbalances in individual markets. Apart from its U.S. portfolio, Medical Properties maintains a strategic exposure to key international markets, including Germany, the U.K., Italy and Australia.

Medical Properties enjoys some competitive advantages. As the only pure-play hospital REIT, with nearly 20 years of experience in its business, it has great expertise within its niche. It also enjoys economies of scale.

As a hospital REIT, Medical Properties is more resilient to recessions than most REITs, as most consumers do not reduce their health expenses even under the most adverse economic conditions. The REIT has proved resilient throughout the coronavirus crisis, with record funds from operations [FFO] per unit in 2020 and 2021. On the other hand, in the Great Recession, the trust incurred a 31% decrease in its FFO per unit and cut its dividend by 26%.

Medical Properties has exhibited a remarkably consistent growth record. It has grown its FFO per unit in nine of the last 10 years, at a 9.3% average annual rate. The consistent performance is a testament to the solid business model of the REIT and its careful execution. Thanks to the tailwind from aging population in most of its markets and a promising acquisition pipeline, Medical Properties is likely to remain on its growth trajectory in the upcoming years.

On the other hand, just like other healthcare REITs, Medical Properties is currently facing some headwinds, namely the impact of inflation on labor costs, a sluggish post-pandemic recovery in patient volumes and the waning of fiscal stimulus packages. As a result, we assume only 0.4% average annual growth of FFO per unit over the next five years, in order to be on the safe side.

Medical Properties has raised its dividend for nine consecutive years and is currently offering a 9.3% dividend yield. The REIT has a decent payout ratio of 64% and a solid balance sheet, with an interest coverage ratio of 2.6. Given also its defensive business model, its dividend should be considered safe for the foreseeable future.

Medical Properties is currently trading at a nearly 10-year low price-to-FFO ratio of 6.9, which is much lower than the historical average of 12.5 of the stock. The exceptionally cheap valuation has resulted from the aforementioned headwinds and the impact of inflation on the present value of future cash flows. As soon as inflation begins to subside, the FFO multiple is likely to begin to revert towards its historical average. We thus expect a 12.6% annualized valuation tailwind over the next five years. Given also the 9.3% dividend and 0.4% growth of FFO per unit, we believe the stock can offer a total annual return of 18.5% over the next five years.

This REIT Gives at the Office

Office Properties Income Trust (OPI)  is a REIT that currently owns more than 160 buildings, which are located in 31 states and are primarily leased to single tenants with high credit quality. The portfolio of the REIT currently has a 90.7% occupancy rate and an average building age of 17 years.

Office Properties generates 64% of its rental income from investment-grade tenants. This is one of the highest percentages of rent paid by investment-grade tenants in the REIT sector. It is also remarkable that U.S. government tenants generate approximately 20% of rental income while no other tenant accounts for more than 4% of annual income. Overall, Office Properties has an exceptional credit profile of tenants, which results in reliable cash flows and thus constitutes a significant competitive advantage.

On the other hand, Office Properties has a high debt load, with its interest expense currently consuming essentially all its operating income. Consequently, the trust is in the process of selling assets to reduce its leverage. The deleverage process has been taking its toll on the performance of the REIT during the last two years.

In the third quarter, the occupancy rate of Office Properties dipped from 94.3% to 90.7% and its normalized FFO per unit declined 10% over the prior year’s quarter. Due to asset sales and the expiration of some leases, FFO per unit have decreased 19% in total in the last two years and are poised to decrease by another 3%-4% this year.

Moreover, the coronavirus crisis may lead many companies to adopt a permanent “work from home” model in order to reduce their operating costs. Such a shift would hurt Office Properties in the long run, though it is too early to evaluate the effect of the pandemic on this trend. Due to the burden of the high debt load on the performance of Office Properties and the headwind from the “work-from-home” trend, we expect just 2% average annual growth of FFO per unit over the next five years.

Office Properties has frozen its dividend for four consecutive years but it is offering an exceptionally high dividend yield of 15.7%. The REIT has a healthy payout ratio of 47% but it has an excessive debt load. As a result, its dividend may be cut in the event of a recession.

On the bright side, the stock is currently trading at a nearly 10-year low price-to-FFO ratio of 3.0, which is far lower than its 10-year average of 8.0. Due to the high leverage of the REIT, we prefer to be conservative and thus assume a fair price-to-FFO ratio of 6.0.

If the stock reaches our fair valuation level in five years, it will enjoy a 15.0% annualized gain in its returns. Given also the 15.7% dividend and 2.0% growth of FFO per unit, Office Properties can offer a total annual return of 24.7% over the next five years.

Crack This Safe for Income

Safehold (SAFE) became public in 2017, with iStar as its manager and primary investor. To this day, iStar remains the majority shareholder, though it is limited by statute to only controlling 42% of the voting stock for corporate governance purposes.

Safehold is a ground lease REIT, which aims to revolutionize the real estate industry by providing a more capital efficient way for businesses to own buildings for their businesses. The trust engages in long-term sale and leasebacks of land underneath commercial properties across the U.S. and is the only REIT focused exclusively on ground leases to support real estate investment and development.

Safehold is an early mover in the sale and leaseback ground lease sector. As a result, it benefits from offering innovative and unique lease products, which provide the REIT with wide profit margins and ample room for future growth. However, there are few barriers to entry in this business and hence the competitive advantage of the trust may not prove durable.

Safehold currently enjoys strong business momentum. In the third quarter, it grew its revenue 52% over the prior year’s quarter thanks to several new originations and nearly tripled its FFO per unit, partly thanks to a non-recurring profit from the sale of a ground lease. The REIT bought the ground lease in December 2020 for $76.7 million and sold it in the third quarter for $136 million. Thanks to its sustained business momentum, the REIT is on track to grow its FFO per unit by nearly 30% this year, to a new record level.

Safehold is the leader in a massive total addressable market estimated to be $7 trillion. However, rising interest rates exert pressure on the net asset value (NAV) of the REIT. Therefore, we assume 2.7% average annual growth of the NAV of the REIT over the next five years.

Moreover, the trust is currently offering a 2.4% dividend yield. While this yield is much lower than the yields of Medical Properties and Office Properties, the dividend of Safehold is much safer than the dividend of the other two REITs, primarily thanks to a solid payout ratio of 35%.

Safehold is currently trading at a nearly five-year low price-to-NAV ratio of 0.62, which is much lower than our assumed fair valuation level of 1.0. As soon as interest rates begin to moderate, we expect the REIT to revert towards its fair valuation level. If the stock trades at its fair valuation level in five years, it will enjoy a 12.6% annualized gain in its returns. Given also the 2.4% dividend and 2.7% growth of NAV per unit, Safehold can offer a total annual return of 17.0% over the next five years.

Final Thoughts

The above three REITs have become exceptionally cheap due to their selloffs, which has resulted primarily from the impact of 40-year high inflation on their results and on their valuation.

We expect inflation to begin to subside next year thanks to the aggressive policy of the Fed, which has prioritized restoring inflation to its long-term target of 2%. Whenever inflation moderates, the above three REITs could reward investors.