Hidden Vaccine Value in Diversified REITs | July 2021

As we wrote in March 2021, we believed the rotation from growth to value (or COVID to Vaccine) REITs had created a buying opportunity for high quality companies with long term growth potential, such as cell tower REITs.  For example, from November 6, 2020 to March 1, 2021, the average performance for the lodging, regional mall, and shopping center sectors (Vaccine REITs) was +78%, which compared to the average performance of -9% for the data center, cell tower, and industrial sectors (COVID REITs).  Since we published ‘Rotation Creates Long Term Buying Opportunity’ on March 1, 2021, these COVID sectors have produced a total return of +22% versus only +12% for these Vaccine sectors through June 24, 2021.  While the gap has closed slightly, we still believe many of the Vaccine REITs are ‘priced for perfection’ and thus present a valuation risk if rent and occupancy recovery times are pushed out. 

However, we omitted a sector that was left out of both trades: Diversified.  While diversified REITs share property types with many of the COVID REITs, they have not recovered to the same extent.  From November 8, 2020 to March 1, 2021, the diversified sector (as defined by Chilton) produced an average total return of +44%.  Though the performance was above the MSCI US REIT Index’s +15% return over the period, it was nowhere near their closest peers in the Vaccine REIT sectors.  Furthermore, from March 1, 2021 to June 24, 2021, the average diversified REIT was up only +8% versus the MSCI US REIT Index at +17%.  Thus, instead of adding exposure to the Vaccine trade via focused sectors that have gotten ahead of themselves from a valuation standpoint in our opinion, we have identified several diversified REITs that are underappreciated when using a sum of the parts (or SOTP) valuation technique from comparable peers by property type.   

Diversified REIT Landscape

Diversified REITs are so named since they focus on multiple property types, most notably, shopping centers, office, industrial, and multifamily.  One of the most important management functions of a REIT is capital allocation, and a diversified property type landscape allows these teams to see a wider range of investment opportunities at any given time.  This creates more room for error, but also opportunity especially when one property type is overvalued and can be sold to purchase an undervalued property type.  

Often, a diversified REIT specializes in a geographic area such as American Assets Trust (NYSE: AAT) on the West Coast and Armada Hoffler (NYSE: AHH) in the Mid-Atlantic and Southeastern US.  Alexander & Baldwin (NYSE: ALEX) is exclusively focused on Hawaii with its commercial real estate portfolio.  CTO Realty Growth (NYSE: CTO) is a REIT in transition from a land rich Florida company to a growing portfolio of retail and office properties with a Sunbelt orientation.  The Chilton REIT Strategy owns all four of these companies due to the current discounted valuation and potential for earnings growth that is underappreciated in the public market, perhaps precisely due to the ‘diversified’ wrapper.  However, we are patient investors who believe the market will eventually appreciate the relative risk-adjusted return opportunity.

American Assets Trust

American Assets Trust (NYSE:  AAT), headquartered in San Diego, prides itself on investing in ‘Coastal West Coast’ with a 50 year track record in various property types including office, shopping centers, multifamily, and mixed-use.  The COVID pandemic was particularly hard on its operations in Hawaii where it owns the 369 room Embassy Suites Hotel in Waikiki and nearby street retail (96,907 sqft) as the local government placed severe restrictions on this normally popular travel destination.  As a result, the net operating income (or NOI) from these assets alone fell from $24.5 million in 2019 to $4.2 million in 2020, a drop of $20.3 million ($0.26 per share).  Tourism is now rebounding in Hawaii and the company anticipates NOI of $20 million in 2022 and a full recovery by 2023.  

A second major growth driver is coming from the office portfolio due in large part to the re-leasing of the majority of The Landmark at One Market Street (422,000 sqft) in San Francisco to Google.  In total, NOI for the office component (9 properties containing 3.4 million sqft) is expected to increase from $87 million in 2019 to $130 million ($0.56 per share) by 2022.  The combination of these two sources coupled with a recovery in retail should produce one of the best growth rates in Adjusted Funds from Operations (or AFFO) per share across the entire REIT sector over the next two years according to our estimates.

Armada Hoffler Properties

Armada Hoffler Properties (NYSE:  AHH), headquartered in Virginia Beach, focuses on the Mid-Atlantic and Southeastern United States.  It provides investors with almost 40 years of experience in all the core property types plus it owns its own commercial construction company, which is unique in the REIT universe.  In the current environment of rising construction costs across all property types due to materials and labor, we feel the construction capabilities give AHH an edge in cost estimates and maximizing development yields.   

The company places a great deal of emphasis on development as it believes it is the best source of creating value for shareholders.  Currently, the active pipeline totals $593 million, which management believes will stabilize at a market value of $725 million.  The value creation of $132 million ($725 million minus $593 million) would equate to a $1.63 per share gain for shareholders using the share count as of March 31, 2021.  Compared to the AHH stock price of $13.96 per share as of June 24, 2021, development alone could increase the stock price by 12%.  

Almost 30% of the portfolio is comprised of Class A office, retail, and multi-family properties located in the Virginia Beach Town Center that the company built in a public/private partnership with the city that started in the late 1990’s.  In Baltimore, AHH is essentially building a second town center in the Harbor area.  The company developed Thames Street Wharf, which is a 263,000 sqft office building leased to Morgan Stanley and Johns Hopkins Medicine.  Nearby, a second tower called Wills Wharf is in lease-up, boasting Canopy by Hilton, RBC, Ernst & Young, and Jellyfish as tenants.   In June, Transamerica announced it had leased 35,000 sqft, bringing the leased percentage to 58% for the 327,000 sqft building.  In December 2020, AHH announced that it had been selected to build a new global headquarters for T.Rowe Price in a joint venture that will span 450,000 sqft at a cost of $250 million.  AHH also developed an apartment building next-door called 1405 Point Street containing 289 units, and will participate in a joint venture to finish out a mixed use component in an adjacent land parcel.  

Once the current development pipeline is stabilized, the company will have an even balance by property type between office, shopping centers, and multifamily.  Also management estimates that NOI should increase from $119 million in 2021 to $177 million at full stabilization which should occur by 2024.  This is equivalent to a 40% increase in NOI, and would represent about $0.70 per share of earnings growth using the March 31, 2021 shares outstanding.

Alexander & Baldwin

Alexander & Baldwin (NYSE: ALEX) only invests in Hawaii (principally Oahu and Maui) and has a 150 year track record in this State.  They are the largest owner of grocery-anchored shopping centers in Hawaii and that portion of the portfolio accounts for about 64% of the total sqft.  They also own industrial properties, ground leases, and office to a lesser extent.  

In 2020, operating profit declined by $16.4 million from 2019, or $0.22 per share, due to the pandemic.  The company also has two significant non-core businesses, including a land bank of 26,700 acres (mostly agriculture) and Grace Pacific, a materials and construction business.  Together, they are not a significant nor predictable contributor to earnings on a regular basis.  Management is committed to the monetization of both at the right time but provide no guidance on timing or value.  Together, they represent $450 million in assets based upon the 2020 10K Annual Report.  Assuming the assets are sold for gross book value (which should be conservative) and reinvested into income producing real estate at a 5% yield, it would produce about $0.30 per share of earnings growth.  This compares to 2021 funds from operations (or FFO) guidance of $0.73 per share at the midpoint.  

Accordingly, we are convinced that the valuation of ALEX should improve once it is a pure-play on income producing real estate and reap the benefits investing the proceeds of sale.  The barriers to entry for real estate development are high in Hawaii due to local politics, which can create a 9-15 year wait between application and actual ground-breaking.  As a result, the retail square footage per capita in Honolulu is among the lowest of most major cities in the US.  

Major growth drivers include value-add redevelopment of existing assets, occupancy improvement in the retail portfolio concurrent with the re-opening of Hawaii to tourism, and rent resets on the ground lease portfolio.  External growth via acquisitions will occur as the land portfolio is sold and once the company receives proceeds from the sale of the aforementioned Grace Pacific unit and land.  In the first quarter of 2021, the company received a record $29 million of cash proceeds from land sales as demand accelerated during the pandemic.

CTO Realty Growth    

CTO Realty Growth is the product of a conversion of a Florida land company called Consolidated Tomoka to a REIT with shopping centers and office properties in Sunbelt cities.  CTO converted to a REIT in 2020, and spun off most of it single tenant retail properties into Alpine Income Properties (NYSE:  PINE)  in 2020 as well, leaving CTO with mostly multi-tenant properties but still a 1600 acre land bank.  On June 24, 2021, CTO announced that the land joint venture had closed on a transaction with Timberline to sell the remaining 1600 acres, which will result in a $26 million distribution to CTO, equivalent to $4.35 per share.  Assuming the cash is reinvested at a 5% cap rate, the recycling of this capital from non-income producing to income-producing real estate could add $0.22 per share in FFO.  This would be a 6% increase based on 2021 FFO guidance of $3.80 to $4.10 per share. 

Upon completion of a recently announced purchase of The Shops at Legacy West in Plano, TX, CTO will be comprised of about 70% shopping centers, 28% office, and 2% in a hotel.  The company has another $5 to $20 million in non-earning assets it needs to sell to get to where it wants to be, but we believe the land transaction gets it close enough to where investors can get much more comfortable placing a higher multiple (or lower dividend yield) on the stock.  As of June 24, CTO trades at a dividend yield of 7.5%, which compares to the average shopping center dividend yield of 3.0% and the average office dividend yield of 3.1%.

Chilton Overweight to Diversified REITs

The Chilton REIT Composite’s investments in the above four companies total 7.3% as of June 24, 2021, which compares to the benchmark diversified allocation of 0.9% (using Chilton’s sector definition).  The recent underperformance by these companies is likely explained by a general investor preference for ‘pure-play’ REITs, but also could be due to some of the ‘hair’ on each story.  As shown in Figure 5, the multiple expansion opportunity is significant based merely on public comparable multiples.  Whether it’s non-core asset sales or an outsized development pipeline stabilizing or signed leases turning to cash rent payments, each of these companies has catalysts in the near future for higher earnings and thus warrant higher multiples.  We believe that the earnings growth will triumph over any narrative about pure-play versus diversified, and all of this can be done with taking less risk due to the lower entry multiple.  

Matthew R. Werner, CFA
(713) 243-3234

Bruce G. Garrison, CFA
(713) 243-3233

RMS: 2704 (6.30.2021) vs 2220 (12.31.2020) vs 346 (3.6.2009) and 1330 (2.7.2007)

Previous editions of the Chilton Capital REIT Outlook are available at www.chiltoncapital.com/category/library/reit-outlook/.

An investment cannot be made directly in an index. The funds consist of securities which vary significantly from those in the benchmark indexes listed above and performance calculation methods may not be entirely comparable. Accordingly, comparing results shown to those of such indexes may be of limited use.

The information contained herein should be considered to be current only as of the date indicated, and we do not undertake any obligation to update the information contained herein in light of later circumstances or events. This publication may contain forward looking statements and projections that are based on the current beliefs and assumptions of Chilton Capital Management and on information currently available that we believe to be reasonable, however, such statements necessarily involve risks, uncertainties and assumptions, and prospective investors may not put undue reliance on any of these statements. This communication is provided for informational purposes only and does not constitute an offer or a solicitation to buy, hold, or sell an interest in any Chilton investment or any other security.

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