3 Reasons The Most Undervalued Blue Chip REIT In America Is A Strong Buy

(Source: imgflip)

Real estate has historically been a great way to get rich over time. And REITs have proven to be the best way to invest in real estate, outperforming both private commercial properties and the market over the past 50 years.

(Source: NAREIT)

And while REITs have recovered nicely since the two-year bear market likely bottomed in February, there are still great bargains to be found in the sector. Let’s take a look at the three reasons why dividend aristocrat Tanger Factor Outlet Centers (SKT) is the most undervalued REIT in America. At least that I can recommend to conservative income investors, such as retirees looking to live off dividends.

That’s because, despite some recent struggles, this time tested REIT has a strong business model that gives it the potential to generate over 16% in long-term annual returns, which is likely three times greater than the S&P 500 is likely to deliver over the coming years. That would be in line with the REIT’s great track record of enriching dividend investors over the decades.

SKT Total Return Price data by YCharts

That means that if Tanger’s turnaround succeeds, then it will prove not just a source of generous, safe, and steadily rising income, but probably one of the best low-risk, high-yield stocks you can buy today.

1. Tanger Factory Outlet Centers: A Dividend Aristocrat REIT With Strong Competitive Advantages

Tanger was founded in 1981 by Stanley Tanger, but went public in 1993. Today, it owns full or partial positions in 44 premium outlet centers in 22 states and Canadian provinces. Its outlet centers are visited by about 188 million customers per year who are looking for an experiential shopping experience focused on discounted name brand products.

(Source: Tanger investor presentation)

Tanger’s success has come from including 80 to 90 leading retailers in each of its centers who are able to eliminate excess inventory. Thanks to its premium quality locations, strong embrace of technology and marketing, and focus on bargain hunting, the REIT’s business model has proven to be highly recession resistant. As Steve Tanger puts it, “in good times people love a bargain, in tough times they need a bargain”.

(Source: Tanger investor presentation)

This is why Tanger has never seen its occupancy rate fall below 95%, even during the worst recession since the Great Depression. That’s partially due to the high volume of bargain hunters Tanger attracts which has historically allowed it to enjoy strong double-digit lease spreads.

(Source: Tanger investor presentation)

Lease spreads are how much the REIT can increase its rent once a lease expires or when it has to replace a failed tenant with a new stronger one. It basically represents the REIT’s pricing power and is a good proxy for the quality of its real estate assets. Strong lease spreads are what drives long-term cash flow and dividend growth. In 2017 and 2018, Tanger’s lease spreads have struggled, but I’ll address its turnaround efforts in a moment.

(Source: Tanger investor presentation)

Tanger enjoys a diversified tenant base with no single customer making up more than 6.9% of annual rent. Better yet, Tanger typically makes long-term leases with its tenants, which are well staggered ensuring highly stable adjusted funds from operation or AFFO. AFFO is the REIT equivalent of free cash flow and what funds the dividend.

(Source: Tanger investor presentation)

That highly stable cash flow is what has allowed Tanger to grow its dividend every year since 1993, and makes it one of the few dividend aristocrat REITs.

(Source: Tanger investor presentation)

But of course, past glories are no guarantee of future results. What really matters to long-term income investors is the future. Fortunately, Tanger has three major competitive advantages that should allow it to generate consistent long-term cash flow and dividend growth.

The first advantage is the nature of its properties. Unlike mall REITs, whose anchor stores are large and specialized, Tanger’s stores are small and relatively easy to prepare for a new tenant should an existing one fail. As Brad Thomas, Seeking Alpha’s REIT guru, puts it, reformating a store for a new tenant “is really as simple as broom sweeping the floor and carpeting the retail space.” This means that it minimizes turnaround time and occupancy cost. Occupancy costs are the % of gross sales represented by rent and landlord fees.

(Source: Tanger investor presentation)

While Tanger’s occupancy costs have risen over the years, they have stabilized at 10%. For context, most mall tenant occupancy costs for similar quality properties are about 15%, or 50% higher.

(Source: National Real Estate Investor)

This means that Tanger’s outlet stores are highly cost effective for retailers and increases its ability to raise rents when leases expire.

The second major competitive advantage is the quality of its management team. Tanger is led by CEO Steven Tanger, who has been in the top job since the 1993 IPO. Tanger is the son of the REIT’s founder and joined it in 1985 (28 years of industry experience). Similarly, the rest of the executive team has a similar pedigree, including averaging over 15 years with the REIT and over 20 years of industry experience.

Why does good management matter? Because ultimately, investors are trusting them to allocate their capital efficiently and profitably. This brings us to Tanger’s final competitive advantage, access to very low cost of capital. That allows it to generate some of the industry’s best gross investment spreads (yield on invested capital minus cost of capital).

Approximate Cash Cost Of Capital

2.5%

Historical Cash Yield On Invested Capital

7% to 9.3%

Gross Investment Spread

4.5% to 6.8%

(Source: earnings releases, earnings supplements, FastGraphs)

Tanger is one of the few REITs with a buyback program, showing it doesn’t rely on fickle equity markets for its growth. Rather, it retains a large amount of its cash flow (about 30%) to fund expansion. The REIT also enjoys very low borrowing costs (3.5% on average) thanks to a very strong credit rating. That’s due to its historically conservative use of debt. Today, just 6% of its loans are secured by its assets, and the REIT has $370 million in remaining borrowing power under its revolving credit facility. When combined with $94 million in retained cash flow each year, that puts SKT’s 12-month liquidity at $464 million.

(Source: Tanger investor presentation)

And with no debt maturing until April 2021, Tanger has a great financial flexibility when it comes to its capital allocation. Thanks to Tanger’s $125 million buyback authorization ($56 million remaining), it’s able to repurchase shares that are the equivalent of achieving a 10.6% cash yield on invested capital. Or to put another way, Tanger’s low share price is actually helping it to grow faster, even if it doesn’t build any new properties.

Ultimately, Tanger’s best competitive advantage is its strong cash flow generating ability. As its CEO told analysts at the most recent conference call:

“The cash we generate covers our capital needs for investing in our assets, paying our dividends, repurchasing our common shares and deleveraging our balance sheet.” – Steven Tanger

But of course, the reason that Tanger is the most undervalued blue chip REIT in America is because its strong business model has been struggling recently. So let’s take a look at how management plans to turn that around and restore the REIT to its historical growth levels.

2. Management Is Confident In The Success Of Tanger’s Fourth Turnaround

It’s important to remember that all blue chips periodically struggle. Tanger has had three previous downturns, two since it went public:

  • 1988 to 1990
  • 1999 to 2001
  • 2008 to 2010

Tanger’s fourth turnaround was necessitated by the high number of retail bankruptcies in 2017 (about 7,000). In 2018, analysts expect about 3,500 more store closures. In Q2, Tanger was affected when Toys “R” Us, Nine West, Easy Spirit, and Rockport filed for bankruptcy, representing 122,000 square feet of Tanger’s stores.

This forced it to shift away from longer-term leases towards shorter (less than 12 month) ones. These are made at below market rents. That is to maintain occupancy at its centers and help preserve strong customer traffic and the health of the rest of its tenant base.

Metric

Q2 2018 Results

First Half 2018 Results

Revenue Growth

0.1%

0.5%

Adjusted Funds From Operation Growth

-0.6%

0.6%

Shares Outstanding

-1.8%

-1.8%

AFFO/share Growth

1.7%

2.6%

Dividend Growth (YOY)

2.2%

3.7%

Payout Ratio

57%

58%

(Source: earnings release)

As a result, the REIT’s growth was essentially flat in the first half of 2018. And most disappointing for income investors, the dividend increase for 2018 was less than half the REIT’s 20-year average of 5%.

Metric

Q2 2017

Q2 2018

Occupancy

96.1%

95.6%

Sales Per Square Foot

$383

$383

Lease Spread (straight line rent, over 12-month term)

21.2%

14.0%

Total Lease Spread (straight line rent)

16.3%

6.3%

(Source: earning release)

The REIT saw its occupancy slip a bit, though still remains strong at over 95%. However, the discounted short-term leases did mean that its overall lease spread fell to just 6.3% in Q2 2018, which is near a 10-year low.

(Source: Tanger Investor Presentation)

That in turn drove organic growth, as measured by same-store net operating income, into the red. So does this mean that Tanger is doomed and its glory days are forever behind it? Not necessarily. Because there are some promising signs that the worst is now over for Tanger.

(Source: Tanger Investor Presentation)

For one thing, sales per square foot have stabilized after bottoming in 2017 and appear to be recovering. In fact, on a same-center basis, sales per square foot increased 1% in the most recent quarter. As a result, the number of leases that Tanger has negotiated on a short-term basis fell from 17% in Q1 2018 to just 5% in Q2. In addition, on a cash basis, the number of these short-term leases to achieve a positive cash spread rose from less than 50% in Q1 to over 70% in Q2. That’s why Tanger’s total lease spread in Q2 was 6.3%, up from 5.3% in Q1.

That signals that Tanger’s turnaround efforts are bearing fruit, and on long-term leases, it was still able to achieve 14% lease spreads. While that’s less than last year’s comparable figure, any number above 10% indicates that the REIT’s properties remain valuable, and that its business model isn’t likely broken.

According to COO Thomas McDonough, the REIT expects the number of short-term leases it needs to offer distressed tenants to moderate in the future. And during the conference call, Steven Tanger reiterated his belief that SKT’s fundamental business model is sound and likely to thrive in the coming years.

“Our confidence in the long-term growth of the outlet distribution channel remains unwavered… Relative to other retail channels, we don’t believe that outlets have been overbuilt… We are increasingly hearing the conviction among retailers that brick-and-mortar is a critical element of their omni-channel brand strategy.” – Steven Tanger

Ultimately, Tanger’s strengths are that it helped pioneer the premium outlet center business model. The REIT has a highly experienced management team, favorable property economics, great financial flexibility, and very strong cash flow. All of which mean that if the turnaround succeeds, this high-yield dividend aristocrat should be able to deliver great total returns over time.

3. Dividend Profile: Generous, Safe and Steadily Growing Yield With Market Crushing Return Potential

The most important part of any income investment is the dividend profile, which is what ultimately determines long-term total returns. This consists of three parts: yield, dividend safety, and long-term growth potential.

REIT

Yield

2018 FFO Payout Ratio

Expected 10-Year Annualized Dividend Growth

Expected 10-Year Total Return Potential

Valuation Adjusted Total Return Potential

Tanger Factory Outlet Centers

6.2%

58%

4.7%

10.9%

16.7%

S&P 500

1.8%

38%

6.2%

8.0%

0% to 5%

(Sources: earnings releases, Morningstar, Gurufocus, Fastgraphs, BlackRock, Vanguard, Multpl.com, Simply Safe Dividends, Dividend Yield Theory, Gordon Dividend Growth Model, Yardeni Research)

Tanger’s 6.2% yield is among the highest of any blue chip REIT’s, and almost 3.5 times the paltry payout of the S&P 500. More importantly, that dividend is very safe, thanks to the REIT’s very low payout ratio. For context, the average mall REIT pays out 86% of its FFO/share.

But of course, there’s more to a safe dividend than just a low payout ratio. In the capital intensive and growth oriented REIT sector, a strong balance sheet is also essential.

REIT

Debt/Adjusted EBITDA

Interest Coverage Ratio

S&P Credit Rating

Avg Interest Rate

Tanger Factory Outlet Centers

5.2

5.2

BBB+

3.5%

Sector Average

5.8

3.4

NA

NA

(Sources: earnings supplement, Gurufocus, Morningstar, FastGraphs)

Fortunately, here too Tanger is a standout. Its leverage ratio is far beneath that of most REITs, and its interest coverage ratio is far higher. That’s why it enjoys a very strong investment grade credit rating that allows it to borrow at cheap interest rates.

(Source: Tanger Investor Presentation)

As importantly, the REIT is at little risk of violating its debt covenants. These are relative debt metrics imposed by creditors. If a REIT violates a covenant, then bonds can be immediately called in, triggering a liquidity crisis that can result in a dividend cut even if the payout ratio is low. But thanks to its conservative use of debt over the decades, this dividend aristocrat’s generous payout is one investors need not worry about. Or to put another way, Tanger is a high-yield SWAN (sleep well at night) stock.

What about long-term dividend growth potential? Well, until Tanger delivers on its turnaround and returns to historical growth rates, payout hikes are likely to remain modest. I expect that 2019’s dividend hike may be similar to 2018’s token amount. However, analysts expect that over the next decade, Tanger will deliver about 4.7% FFO/share growth. If the REIT lives up to expectations, then its long-term dividend growth rate should return to its historical levels (4.7% CAGR).

Combined with the current 6.2% yield, that means that according to the Gordon Dividend Growth Model or GDGM, Tanger should be capable of about 11% annualized long-term total returns. That’s because since 1956, total returns of stable business model dividend stocks (like REITs) have usually followed the formula yield + dividend growth. But that 11% figure assumes that Tanger’s rock bottom valuation never recovers.

When we adjust for valuation, then Tanger’s total return potential rises to 16.7%. That’s good enough to potentially more than quadruple your money over the coming decade. For context, the S&P 500 has historically (since 1871) delivered 9.2% total returns. And from today’s historically high valuations, Morningstar, BlackRock and Vanguard estimate the market is likely to generate anywhere from 0% to 5% CAGR returns over the next five to ten years.

This means that Tanger is potentially capable of more than tripling the market’s returns in the coming 10 years. All while delivering generous, safe, and steadily rising dividends. That’s thanks to its mouth watering valuation, which is the best of any blue chip REIT, and one of the best of any dividend aristocrat.

Valuation: The Most Undervalued Blue Chip REIT In America

SKT Total Return Price data by YCharts

REITs in general have had a rough year, badly underperforming the S&P 500. Tanger has fared slightly worse, thanks to its ongoing turnaround efforts. However, that means that it’s offering a potentially fantastic bargain that value investors might want to snap up.

Now there are dozens of ways to value a stock, but for REITs, two in particular have proven highly useful over time. The first is looking at the price/FFO ratio. That’s the REIT equivalent of a PE ratio. For context, the average REIT’s P/FFO is about 17 right now.

P/FFO

20-Year Average P/FFO

Implied 10-Year FFO/Share Growth Rate

Analyst Expected Growth Rate

9.4

14.4

0.5%

4.7%

(Sources: management guidance, FastGraphs, Benjamin Graham)

Tanger is currently trading at 9.4 times management’s guidance of 2018’s FFO/share. For context, that’s 35% below its 20-year average. And according to a formula developed by Benjamin Graham, Buffett’s mentor and the father of modern value investing, it also means shares are pricing in almost no long-term growth. Tanger shares are pricing in about 0.5% 10-year FFO/share growth, which is nearly 10 times less than analysts expect the REIT to deliver. This implies that if the turnaround succeeds, Tanger’s P/FFO multiple is set to expand significantly, driving very strong share price appreciation. That in turn would mean that Tanger’s total returns would be much better than the GDGM estimates. What kind of long-term valuation boost can Tanger investors expect?

To answer that, I turn to my favorite valuation method for stable income stocks. That would be dividend yield theory, which has a great track record stretching back to 1966. It’s been most famously applied by asset manager and newsletter publisher Investment Quality Trends or IQT.

(Source: Investment Quality Trends)

For over 30 years, IQT’s model portfolio, as verified by Hulbert Financial Digest (which tracks over 125 newsletters), has been crushing the S&P 500. Over the past 30 years, it’s beaten the market by 12% annually while delivering 20% better risk-adjusted returns (lower volatility).

IQT’s entire approach is based on dividend yield theory, which states that for stable dividend stocks, yields are mean reverting. That means they tend to cycle around a relatively fixed point that approximates fair value. Buy when the yield is above fair value yield and your long-term returns will increase when the stock’s valuation returns to its historical norm.

Yield

5-Year Average Yield

13-Year Median Yield

Estimated Fair Value Yield

Discount To Fair Value

Expected Annual Valuation Boost (Over 10 Years)

6.2%

3.5%

3.2%

3.5%

43%

5.8%

(Sources: Simply Safe Dividends, Gurufocus, Dividend Yield Theory)

Tanger’s current yield is far above its five-year average yield and 13-year median yield. These are levels I eventually expect the REIT’s yield to revert to assuming the turnaround succeeds. To be conservative, let’s take the higher fair value yield, 3.5%. Under dividend yield theory, this implies that Tanger is about 43% undervalued. Or to put another way, if management delivers on the turnaround, shares have 76% upside from valuation alone. That doesn’t even factor in long-term FFO/share and dividend growth that would boost its intrinsic value.

Over time, a stock trades purely off its fundamentals, not short-term sentiment. Thus, while I can’t predict how long the turnaround will take (assuming it works), I’m confident that Tanger’s valuation will revert to intrinsic levels over the coming years. For my long-term valuation adjusted total return model, I assume Tanger’s shares will appreciate 76% faster than FFO/share (same rate as dividend growth) over the next 10 years.

That equates to a 5.8% CAGR return valuation boost which makes the long-term total return potential: 6.2% yield + 4.7% dividend (and FFO/share) growth + 5.8% valuation boost (yield mean reversion) = 16.7%. That’s nearly double the market’s historical rate of return. And for a low risk dividend aristocrat, it’s enough for me to call Tanger a “strong buy”.

Of course, that’s only for investors comfortable with its risk profile.

Risks To Keep In Mind

While I’m confident that Tanger will ultimately succeed at its fourth turnaround, nonetheless, it is a bit concerning that the REIT is struggling so much during a booming economy.

(Source: Hoya Capital Real Estate)

For example, retail sales have been growing strongly, which is why blue chip retail REITs like Simon Property Group (SPG) are putting up record results and strong top and bottom line growth.

And while it appears the worst is over for Tanger, its COO warned analysts that “it will likely take several more quarters for the current retail cycle to change.” Specifically, SKT expects that short-term leases, priced at beneath market rents to maintain occupancy, will moderate but persist for some time. That’s why SKT is guiding for SS NOI of -2% for 2018. And management seems to be indicating that positive growth might not return until the second half of 2019. This means that Tanger is a low-risk turnaround stock, but one that isn’t necessarily a coiled spring set to soar anytime soon.

And over the long term, my biggest concern for the REIT is with its focus on centers located outside of major urban areas. REITs like Simon Property Group, Taubman Centers (TCO), and Macerich (MAC) are all getting into the premium outlet center game.

However, these REITs are mostly focused on urban centers, which combine the “treasure hunt” experience that Tanger is famous for, but with added convenience of not having to drive a substantial distance. This is why investors will want to watch Tanger’s key fundamentals closely in the coming 18 months. Specifically:

  • occupancy rate
  • sales per square foot
  • SS NOI
  • lease spreads

In order for Tanger to live up to its potential as a great long-term, high-yield dividend growth stock, all of these metrics will have to return to positive growth. The most important sign that Tanger’s turnaround has succeeded (or not) is the lease spread returning to at least 15%. That would be in line with its historically excellent levels. Should the REIT’s lease spreads languish in the single digits beyond 2019, then it’s possible the business model will have fundamentally weakened. If that happens, the long-term dividend growth and total return potential could become permanently impaired.

Bottom Line: Tanger Is A Deeply Undervalued, High-Yield SWAN Stock

Many strong retail REITs have disproven the notion of the “retail apocalypse” damaging their business models. Sadly for Tanger Factory Outlet Centers’ long suffering shareholders, it has not been so lucky. However, while Wall Street is understandably disappointed in Tanger’s flat growth during a strong economy and rising retail sales, I remain confident that Tanger’s world class management team will be able to successfully turn the REIT around. Just as it’s done on three previous occasions.

In the meantime, the REIT’s strong balance sheet, large amounts of retained cash flow, and stabilizing fundamentals means that its generous and still growing yield remains very secure. And if Tanger does deliver on its turnaround plans, then the stock’s current rock bottom valuation (43% undervalued) means Tanger is likely to become one of the best performing REITs of the next few years.

In fact, if the REIT is able to live up to long-term analyst expectations, Tanger should easily deliver over 16% long-term total returns over the coming decade. That’s potentially three times what the S&P 500 is likely to generate and makes this high-yield dividend aristocrat a “strong buy” for anyone comfortable with its risk profile.

Disclosure: I am/we are long SPG.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.