Sticking with our market cycle / booming economy theme, this week's investment idea covers an attractive REIT with an above average dividend yield that continues to have legs. And while we believe this opportunity has more upside, it'll eventually slow when the market cycle slows. So to those of you who choose to ride this one higher--keep an eye on it because when the market cycle does eventually turn...
STAG: Room to Run, But Watch It closely
Stag Industrial (STAG) is a REIT that pays a big monthly dividend (4.95%), it’s been delivering outstanding price returns, it has even more room to run, but it's also riskier than many investors realize. This article provides an overview of Stag’s strategy, details on the three main factors that drive its price performance, an explanation of why it has performed well in its relatively short life, why investing in Stag is somewhat like putting “lipstick on a pig,” an explanation of what could happened to Stag’s price, and finally our views on how to “play” an investment in Stag.
STAG Industrial, Inc. (STAG) is a real estate investment trust (“REIT”) focused on the acquisition and operation of single-tenant, industrial properties throughout the United States. It also offers a big (4.95%), relatively well-covered (83.9% AFFO payout ratio) dividend that is paid monthly.
Further still, Stag has been delivering very strong total returns (dividends plus price appreciation) since its IPO as shown in the following chart.
One of the things that makes Stag unique is its strategy. Specifically, Stag invests in Industrials properties that have historically been considering too risky for other REITs to consider. However, Stag believes by constructing a portfolio of “less desirable” properties, they can reduce the risk through diversification, while simultaneously keeping expected returns high.
And to some extent, Stag’s strategy makes sense. Specifically, constructing a diversified portfolio can reduce risks and keep total expected returns high, when done correctly. The problem with Stag’s properties is that even though they diversify across many properties (more on this later) they’re still concentrated in “non-primary location” industrials properties, and when the economy eventually turns south, Stag will likely suffer much more so than the overall economy because of its risks (more on this later).
Three Factors That Determine Stag’s Stock Price:
There are three very significant factors that investors should consider with regards to how Stag’s stock price moves. First, Stag is highly sensitive to the market cycle. For example, here is a closer look at Stag’s recent stock price.
It’s important for investors to recognize that when the market pulls back, Stag generally pulls back more. The above chart shows this was the case when the market dipped in mid-2015 and early 2016, as Stag’s price pulled back even more than the market (as measured by the S&P 500 (SPY)). This is because Stag is more sensitive than the average stock to overall economic and market moves. For example, Stag’s beta is over 1 (currently 1.41 over the last year, 1.23 over the last 3-years). The average stock beta is only one, and typically REITs are know for having betas of less than one (because they’re usually far less sensitive to overall market conditions). Stag is significantly more volatile and risky than many other REITs.
The second factor to consider is that Stag is the opposite of “recession proof.” Even though Stag’s price rebounded shortly after the pullbacks in our earlier chart, this will not be the case in a recession. The reason Stag’s price has been so strong since its IPO is because Stag has only existed in an economic recovery period. Market condition have been ideal for a higher-beta, big-dividend stock like Stag. However, when the next recession does arrive, Stag will get hit much harder than the average stock, and it will likely take a very long-time to recover (if ever, depending on the severity of the recession) because many of Stag’s tenants (which are non-prime location renters) will go out of business (lower quality companies like Stag’s tenants go out of business before higher quality tenants) and there will likely be no one else available to step in and rent the vacant properties (again because they are not in prime locations).
The third factor to be aware of is Stag’s high correlation with other REITs. Because so many stock’s trade in baskets, such as ETFs, similar stocks (e.g. REITs) all trade together (their prices go up and down and the same time). In the case of REITs, they’re also very sensitive to interest rates. Specifically, because REITs offer big dividends, they’ve been an alternative to traditional bonds in recent years because interest rates have been so low. But now that interest rates are rising again, bonds are becoming increasingly attractive to some investors instead of REITs. This phenomenon is a significant factor in the movement of Stag’s price.
Lipstick on a Pig:
They say in real estate, it’s all about location, location, location! Stag owns tertiary properties (not primary locations, not secondary locations, but tertiary location properties!). As long as the industrials market is good, so too will Stag likely be good. But when the cycle turns, Stag will fall and it may fall hard.
For some perspective, let’s consider Stag’s investment grade credit rating (it’s currently rated BBB). However, this investment grade credit rating is a little like what led to the financial crisis: bundling up a lot of subprime loans (in this case non-investment grade tenants) and saying because of diversification they’re now investment grade (again, Stag is rated BBB, investment grade). We don’t believe Stag’s price is going to come crashing down anytime soon, (in fact, it’ll likely keep going up for a while as long as the economy remains strong), but when the market turns (and it eventually will) Stag will fall, and it may fall hard.
Stag likes to brag about its strong diversification. For example see the chart below.
But remember, Stag is not really as strongly diversified across industries as the above chart may lead you to believe. Specifically, even though Stag owns real estate across different industries, it’s still all industrial real estate that is located in less desirable (non-prime) locations. So what we are saying is that when “the stuff hits the fan” Stag’s diversification likely won’t really have as much value as management seems to want investors believe.
Next check out this peer comparison that management likes to brag about.
Management claims Stag is more attractive than peers because it pays a higher dividend and it trades at lower valuation multiples. But in reality this is NOT because Stag it more attractive, but rather it’s indicative of Stag’s higher risks. The market recognizes these risks, and Stag’s price has adjusted accordingly. Stag is more risky than its peers.
What could happen to Stag in the future:
If the market keeps booming like it has since Donald Trump won the election, then Stag will likely continue to do well (it has been facing rising interest rate headwinds, but it’s also been able to raise rents and business has been strong). But recall the three factors that affect Stag’s stock price as described earlier. Things could get bad for Stag. Specifically, when the market cycle turns, industrials will boom less. More specifically, industrial-related stocks are early stage cycle rallying stocks, as shown in the following chart.
And secondly, if we enter a recession (they typically happen once every 8-9 years, give or take a few) then Stag will likely fall, and it may fall hard (for the reasons described earlier).
Conclusion (Our Advice):
Basically, the point we’re trying to make is that Stag is attractive, but it isn’t as safe as many REIT investors assume. Specifically, when the market pulls back, Stag tends to pullback more. And further, Stag is a relatively new public company that has only existed during positive economic conditions (i.e. in an economic recovery since the financial crisis). If and when the next recession comes, Stag is going to fall and it will likely fall hard.
Our advice to investors is to understand what you own (i.e non-primary, non-secondary, but yes tertiary property locations), and understand how Stag’s price will likely react under different market conditions. More specifically, consider buying more Stag on market pullbacks (because it will likely have pulled back more than the rest of the market because of its high beta) as long as you don’t believe the pullback is the first leg into a larger market wide recession. Said differently, as long as the market keeps booming, so too will Stag, but when the next recession hits (depending on severity), Stag may get slaughtered.