Investing in REITs: One stock to buy and one to avoid
Real Estate Investment Trusts or REITs have been hit by issues such as high interest rates, lackluster return to office, and overall concerns about an economic slowdown. Infrastructure Capital Advisors CEO Jay Hatfield gives his take on the space in the latest Good Buy or Goodbye.
Hatfield is buying Boston Properties (BXP) because he believes the stock will rally as interest rates fall and that it has an attractive valuation. He also likes the stock because, even though they do have office properties, Hatfield says they tend to cater to sectors that favor work from the office.
A stock Hatfield is avoiding is Prologis (PLD), which owns warehouses. Hatfield says that, unlike office space, warehouse space is "easy to replicate," which means there is a lot of new space coming online. Hatfield also says the stock has a "premium valuation" and that he expects the stock to lag. However, Hatfield says that if interest rates remain high or if there is a recession in the US, you would want to own Prologis because "it's more defensive."
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Video Transcript
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JULIE HYMAN: It's a big noisy universe of stocks out there. Welcome to "Good Buy or Goodbye" brought to you by E*TRADE from Morgan Stanley. Our goal? To help cut through that noise to navigate the best moves for your portfolio. And today, we're scooping out the real estate space, a sector that has gained renewed attention as interest rates have come down.
I'm here with Jay Hatfield. He's infrastructure Capital Advisors' CEO. Jay, thanks so much for being here. Appreciate it. So let's get straight to your buy stock, your good buy today which is Boston Properties. And as we kind of talk through this, one of the things that you're looking at is that interest rates will come down.
But you kind of have a little bit of a different flavor when we're looking at that, because you're looking at what the Fed is doing versus what the ECB is doing. Why is that important for where rates are going and then the feed through to REITs?
JAY HATFIELD: Well, Julie, what a lot of US investors don't realize is it's really a global bond market. It's fine to just focus on US stocks, because we really dominate the whole world. But bonds are fungible. They have low default rates. And so it's a global market.
So we actually started focusing on the fact that rates are running up. And we said, why. Well, it's because the ECB is so tight. Well if they're so tight, their economy can't be doing well. And then when you really look, it's terrible. It's 3% below what the US is running at. So they have a negative growth last quarter. It's tracking at negative 1.2.
So we're bullish unlike a lot of strategists that the ECB will cut. We're worried the Fed will be slow. But if the ECB cuts, global rates will drop and that will benefit our markets. We're not dependent, like most people are, on the Fed because we look at all the global bond markets--
JULIE HYMAN: Yeah.
JAY HATFIELD: --which really drive interest rates.
JULIE HYMAN: Well, real estate investment trusts tend to be interest rate sensitive and benefit when rates come down. So that's one of the things you're looking at--
JAY HATFIELD: Correct.
JULIE HYMAN: --when it comes to Boston Properties. But I want to talk specifically about office REITs and why a company like Boston Properties because offices have not been in favor.
JAY HATFIELD: Right.
JULIE HYMAN: So why is that going to change?
JAY HATFIELD: Yeah, so offices in general are really well hated as some of them should be.
JULIE HYMAN: Yeah.
JAY HATFIELD: But the distinction that has to be drawn is between really a-plus offices like we have here in Manhattan, for instance. Boston Properties owns what used to be called the General Motors building. So like a real trophy asset. And for the sectors that they cater to like financial services, they do work from office.
When I started on Wall Street, we did LFO which is live from office. And so unless you want to be fired in financial services, you do go in. And AI, when you talk to brokers, is a very in-office. That's all-hands-on-deck. Also LFO. So we think the fundamentals are improving but only for a-plus buildings. We're not saying run out and buy every office [? three. ?] This is the best largest premier developer in the United States.
JULIE HYMAN: Gotcha. And then you're also looking at the valuation here. Your price target, if you look at the funds from operations which is a measure of cash flow that folks look at when they're measuring REITs, your price target on that base is $94.
JAY HATFIELD: Correct, yes. So we think that another way to look at valuation is just it's a simple number. It's the cap rate. So that's just the cash return on investment. So normally-- so normally, these trophy office buildings used to be at 4% to 5% cap rates. Now they're at 7% And so we think there's a 20% to 30% as they start to catch up to where they were before. And in fact, BXP is down 50% since the pandemic on a price basis.
JULIE HYMAN: Yeah. And one of the things we like to ask first is what could go wrong with this bullish case here. And maybe we don't see rates go down at the--
JAY HATFIELD: Right. Yeah, so we probably have the highest target on Wall Street for the S&P. So we're at 5500, which is a Goldilocks scenario, 2% growth, falling interest rates. So particularly, if rates did not fall like say-- let's say the ECB doesn't cut, which is, I guess, possible, not prudent, but possible, I could definitely see the Fed not cutting and maybe rates go higher.
And BXP and most REITs are more than 50% correlated with interest rates. So you're absolutely not going to make money, unless rates keep dropping.
JULIE HYMAN: Gotcha. OK, so let's get to the stock that you want to avoid and that's Prologis which has done very well, right? And that's part of your case. But what we're seeing now-- and Prologis is an owner of warehouse space. And so you say now as we're seeing the pandemic boom sort of slow down, online retailers are not expanding as much in the warehouse.
JAY HATFIELD: Correct. And then the other thing that if you really think about warehouse space, it's easy to replicate. So if you drive on I-95, you'll see a lot of Prologis but very difficult to replicate office. So there's very few, if any, offices being built, but a lot of new space coming on.
And as you mentioned, Amazon is trying to optimize their distribution. So it's not like it's terrible. But this is a premium valuation, which is another point, I guess, but--
JULIE HYMAN: Yeah, let's-- let's talk about that real quick, because I did look at a chart here of these price to FFO that--
JAY HATFIELD: Right--
JULIE HYMAN: [INAUDIBLE] that we earlier talked about. Here's Prologis. And this is a five-year chart. It's a longer term chart. And here's BXP which--
JAY HATFIELD: Right.
JULIE HYMAN: --looks at that valuation gap.
JAY HATFIELD: Yeah, so they're trading at 24 times. BXP is at 10. And again, if you think the other way to look at it is cap rates that they're going to compress. Because these are both trophy properties. If you've got these CBD and the gateway cities, they're going to be worth a lot at some point, if the fundamentals improve just as they are for PLD.
So we think that the gap will close. But we're not really saying short PLD because we think that BXP will come up and get closer--
JULIE HYMAN: Gotcha.
JAY HATFIELD: --to PLD.
JULIE HYMAN: And then your final point on this one too is that you think small caps are going to do a bit better and Prologis is now the largest REIT by--
JAY HATFIELD: Correct.
JULIE HYMAN: --market cap.
JAY HATFIELD: Yeah, that's 11 times bigger than BXP. So it's defensive just like large cap tech is. So it's what people buy Or hedge funds will go long, PLD in short if the market's bad.
JULIE HYMAN: So what's the risk to this bearish call here? It's kind of the-- the flip--
JAY HATFIELD: I would--
JULIE HYMAN: --of the--
JAY HATFIELD: --say--
JULIE HYMAN: --other.
JAY HATFIELD: Well, the interest rates are tough. But also if there's a recession in the US, you'd really want to be in PLD. It's more defensive. Office space is very variable. We already saw-- we think the cycle is over. But financial services, companies lay off. We saw tech layoffs a couple of years ago.
So if we have a major recession, office employment will get much harder, get hit harder than just warehouse space. And also the occupancy rate now is higher on warehouse. So it will act defensively. And you really should have flipped the good buy and goodbye.
JULIE HYMAN: And just quickly, what's your positions in the two stocks?
JAY HATFIELD: Yeah, so BXP, we hold in our large cap dividend fund, ICAP, and also in our hedge fund. And then, thankfully, we have no position in PLD. So sometimes, we actually will have small positions in companies we think will underperform. But we don't have any position in PLD.
JULIE HYMAN: All right, Jay, I'm going to sum up what we have talked about here. We're going to recap. You're telling investors to buy Boston Properties based on attractive valuations, expectations for strong leasing demand for office buildings, and REITs, overall, continue to rally offices, in particular.
On the other side, you're saying avoid Prologis, the warehouse boom slowing down. Online retailers aren't spending as much. And the stock's valuation. Looks full. Jay Hatfield, thank you so much for being here. Really appreciate it.
JAY HATFIELD: Great. Thanks, Julie.
