The financial sector has been pummeled in 2020 in reaction to efforts to stem the coronavirus pandemic. Banks and real estate investment trusts (REITs) -- especially mortgage REITs -- have underperformed the markets in general and many have fallen further than the market in general.
Have these REITs been sold to the point where they are cheap enough to invest in? Let's take a look at two of these retail REITs and see what they have to offer and which might be the better buy.
Realty Income: the triple-net lease model
Realty Income (NYSE:O) aka the Monthly Dividend Company, is one of the stalwarts of the retail REIT sector. Realty Income is a triple-net lease company, which means the tenant is responsible for taxes and maintenance. Triple-net leases are generally the lowest risk for the REIT, and often carry longer terms with automatic rent escalators.
Realty Income has 6,483 properties, which are generally freestanding with a single tenant. Retail accounts for 83% of its tenant exposure. The five biggest clients are Walgreen's, 7-Eleven, Dollar General, FedEx, and Dollar Tree. These are probably the most recession-resistant customers possible. The stock is trading at 18 times funds from operations (FFO), and FFO covers interest expense 3.8 times. The debt-to-FFO ratio is 7.6x.
Regency: the gross lease model
Regency Centers (NASDAQ:REG) has a different business model. It is one of the largest shopping center REITs, and its leases are gross leases, not triple-net. Regency focuses on shopping centers that are anchored by a grocery store. This is different than Realty Income's focus on single-tenant freestanding properties.
Gross leases tend to have higher payments, all things being equal compared to triple-net leases. Regency's biggest tenants are Publix, Kroger, Albertsons, TJX Companies, and Whole Foods. Retail accounts for 50% of Regency's income, followed by services at 30% and restaurants at 20%. Regency has $3.9 billion in debt and luckily has only $153 million of that debt maturing in 2020 and $174 million coming due in 2021. Funds from operations cover interest expense 4.3 times, which means the company does have some breathing room.
Note that 36% of Regency's rent comes from shop-space tenants, which are under 10,000 square feet. These tenants are the most vulnerable to an economic shock like we are having right now. Regency estimates that each 1% decline in shop space occupancy will hit base rent by $5 million. Think of how many dry cleaners, apparel stores, non-chain restaurants, etc. are going to go out of business if this crisis keeps up and you see that Regency has some concerns ahead of it.
Historical perspective and a rough situation right now
Below is a chart showing both companies' dividend yields over time. At current levels, we are still below average, although pre-2008 levels were in a different interest rate environment. That said, this chart doesn't really indicate that the companies qualify for "beaten down" status quite yet.
Suffice it to say both companies are going to struggle in the current environment. While grocery stores remain open, many of the other retailers will be shut. Restaurants and fitness clubs will struggle to make their rent payments, and this will affect net operating income.
Unfortunately, we don't have any sort of clue what longer-lasting effects the coronavirus outbreak will end up having on the economy. Both companies are at risk of missing Wall Street estimates in upcoming earnings reports, and a dividend cut for either (or both) isn't out of the question. During the 2008-09 Great Recession, Realty Income did maintain its steady policy of dividend hikes. Regency did not, and cut its dividend 36% in early 2009.
Note that both stocks don't have a lot of cash on the balance sheet, either; they have enough for a few months' interest expense, and that is it.
The punch line: Pass on both
Both stocks have been around since the 1960s, so they have weathered an economic shock or two. Realty Income is probably more insulated from an economic shock than Regency, but both companies are going to be affected by this current crisis. It is inevitable.
During the Great Recession, both stocks had double-digit dividend yields. Neither stock is even remotely close to those levels. At this stage, they just aren't cheap enough to buy. Both stocks should be avoided until we can at least get a sense of the extent of economic damage the coronavirus crisis will cause.