“In business,” Warren Buffett has said, “I look for economic castles protected by unbreachable moats.”
By that, he means well-built companies that don’t take what they’ve built for granted. They’ve either:
- Entered into economic areas that are hard to conquer
- Taken measures since starting up to make their areas exceptionally complicated to enter.
Either way, their profits are protected against all but the most intense of attacks. That’s what moats were designed to do for castles back in medieval times.
As I wrote in an April article, “3 Fortress REITs to Own During the New Era of Physical Distancing“:
“… the truth is that castle-storming back in the day was supposed to be a long shot. Only extreme levels of planning, plotting, and resources could pull them down.
“They were built to be fortresses, strategically designed with features such as:
“Arrowslits – Holes up high in the structures from which archers could let their weapons loose while remaining largely protected.
“Keeps – Towers that rose as high up as possible to give great views of whatever might be coming…
“Portcullises – Heavy metal gates to protect main entrances.
“Barbicans – Fortresses outside of the fortress designed to be the first line of defense.”
But out of all of that, you could make a very convincing argument that moats were the most useful protection possible.
Again, castles were designed with safety in mind. And once they were really built, God save the peasant who tried to take them on.
If someone wanted to attack them, they were going to have to put in some significant effort, amassing armies with the right training, motivation, and equipment necessary to take them down.
Of course, as medieval history shows, that sort of thing could and did happen sometimes:
- Arrowslits were only as good as the number of arrows and other weapons available. Once defenders ran out of things to hurl at the enemy, what was their point except for peeking through?
- Keeps were great for spotting trouble far enough ahead to call everyone to the castle. After that though, they became a little less useful.
- Portcullises could be broken through with heavy- and persistent-enough battering rams.
- Barbicans could be overwhelmed with the right amount of equipped people involved.
The point of a moat was to make those success stories even fewer and farther between than they already were. After all, it’s a lot harder to ram a gate down if you can’t reach the gate in the first place. And the same goes for scaling walls.
Like building a castle, nobody starts a business to let it fail. They do their best to build it wisely and profitably – and then, once it’s built, they do their best to guard against competitors.
But, as we know, businesses fail all the time. They get cocky or complacent or bought out or edged out.
If they’re surrounded by moats, their chances of getting edged out become very slim. And as for being bought out, let’s just say it’s much more likely they’ll be bought up or bought into…
By someone like Buffett.
Who, incidentally, sets very high investment standards all around.
Above and Beyond Mere “Moating”
Having very high investment standards helps protect against the other two reasons listed above about why businesses fail: getting cocky or getting complacent.
To address both very real issues, here’s Buffett again:
“… we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year. That doesn’t necessarily mean the profit will be more this year than it was last year, because it won’t be sometimes.
“However, if the moat is widened every year, the business will do very well. When we see a moat that’s tenuous in any way – it’s just too risky. We don’t know how to evaluate that. And therefore, we leave it alone. We think that all of our businesses – or virtually all of our businesses – have pretty darned good moats.”
To paraphrase that short speech, never put your money into a company that takes its moat for granted.
To be clear, no business is ever completely protected. There are always risks involved in running a business or, as a result, in investing in one. Nothing is certain, as Buffett himself found out with his recent airlines debacle.
All the same, when your portfolio is full of enough moat-surrounded companies concerned with proper upkeep… your chances of making money go up enormously.
That’s about as protected as you’re going to get.
A Few Wide-Moat REITs We’re Buying Now
Given the uncertainty related to COVID-19, we’ve been focused almost exclusively on the highest-quality REITs.
This widespread volatility has impacted many property sectors. Business models have become exceedingly stressed due to weakened rent collection in both April and May.
As the U.S. economy begins to open back up, investors are getting more clarity as it relates to rent collection… and the so-called “new norm.” Although most REITs have pulled back guidance for 2020, there are numerous ways to model future cash flows and dividend safety.
At iREIT on Alpha, we seek to own REITs that can not only fend off competition; they can also earn high returns on capital for many years to come. These “moat-worthy” companies can increase earnings – returning cash to shareholders via dividends – and compound intrinsic value.
In the REIT sector, we carefully analyze the major sources of competitive advantages (the moats) including:
- Scale Advantage
- Cost of capital advantage
The first and second pillars are correlated to the third because it’s the management team steering the vessel. We believe that evaluating the pilot is essential to understanding how well a vehicle flies… recognizing that the capital structure can have a profound impact on returns.
During this pandemic, we’ve been throttling down by buying more shares in these REITs:
All three stalwarts have fallen by 40% or more since March 10, the beginning of the U.S. portion of the pandemic. They’ve since recovered by roughly 50%.
That’s noteworthy enough. But let me highlight why we’ve been busy gobbling up the shares instead of panicking…
Omega Healthcare Is Set to Stay
Omega Healthcare is the largest REIT owner of skilled nursing assets, with a portfolio of 966 operating facilities through 70 operator relationships. OHI’s “scale advantage” is impressive – one of the main reasons it’s been able to manage various cycles while delivering steady earnings and dividend growth.
OHI focuses on leasing long-term facilities to strong local and regional operators utilizing triple-net master leases. Its operators receive revenue through Medicare and Medicaid reimbursements, as well as private pay.
In addition, the Department of Health and Human Services (HHS) announced about a $4.9 billion distribution from the CARES Act to skilled nursing facilities to help combat the COVID-19 pandemic.
That aid should ensure SNF operators stay solvent to pay their rent obligations and that OHI can continue generating reliable earnings growth.
Another “moat advantage” for OHI is its balance sheet. It contains significant liquidity with around $1.1 billion of cash and credit facility availability. The company’s conservative leverage metrics include:
- Funded debt/adjusted pro-forma earnings before interest, taxes, depreciation, and amortization (EBITDA) of 5.2x
- Fixed-charge coverage of 4.1x
- More than $9.8 billion of unencumbered real estate assets
- Commitment to an investment-grade profile (BBB-).
As referenced above, the management team plays a critical role. Its CEO, COO, and CFO have an average tenure of over 18 years, showing commitment to the company.
It’s because of this that OHI has continued building upon its impressive dividend growth record of 17 consecutive yearly increases.
We maintain a Buy rating on this moat-worthy REIT, which is now trading at $31.59. That means it has a P/FFO (funds from operations) multiple of 10x and a dividend yield of 8.5%.
Source: FAST Graphs
The Realty Income Deal
Our next “moat worthy” Buy is Realty Income, a net lease REIT that’s my largest position.
As the largest net lease REIT in the peer group, this company enjoys a sizable scale advantage. With over 6,500 properties in 49 states, its rent checks are generated by 630 different tenants in 51 industries.
In terms of pandemic risks, Realty Income does have exposure to theaters, gyms, and restaurants – all industries that are experiencing difficulty related to social distancing. As such, in April, Realty Income reported receiving 84% of its rent and 82% in May.
It continues its rent deferral discussions with most of those delinquent tenants. And it says it collected 82.1% of contractual rent due from its top 20 tenants in April and 98.2% from its investment-grade tenants.
I maintain that nobody could have predicted the pandemic. However, Realty Income was nonetheless prepared by adequately diversifying its revenue stream.
In addition, it’s always maintained strong discipline regarding its balance sheet, with:
- Available liquidity of $4.042 billion
- Fixed-charge coverage ratio of 5.5x
- Net debt/adjusted EBITDARre of 5x
- Credit ratings from Moody’s and S&P of A3 and A-m respectively.
This is another company with an excellent management team. They’ve given it a powerful scale and cost of capital advantages. And those, in turn, have allowed it to maintain an impressive growth record of 26 annual dividend increases in a row.
For the record, it’s also 106 total increases since its 1994 NYSE listing.
We maintain a Buy rating on this moat-worthy REIT that’s now trading at $57.20. It has a P/FFO multiple of 17.3x and a dividend yield of 4.9%.
Analysts estimate that FFO per share will decline by 2% in 2020 and increase by 5% in 2021 – which would be a return to its normal growth rate.
Source: FAST Graphs
W. P. Carey Comes Out Strong
My final moat-worthy pick is W. P. Carey. It’s a unique net lease REIT that offers powerful scale advantage by investing in mission-critical office and industrial properties.
Holding 1,215 properties, WPC is one of the largest owners of net-lease assets. It’s also among the top 20 REITs in the MSCI U.S. REIT Index.
The company’s portfolio is well diversified through its 352 tenants… the top 10 of which represent 21.7% of its annual base rent (ABR).
It’s obvious that COVID-19 has disrupted certain property sectors. Yet WPC’s business model is rooted in:
- Corporate headquarters
- Key distribution facilities
- Manufacturing plants
- Critical research and development facilities
- Data centers
- Top-performing retail stores (with limited exposure in the U.S.).
This is how it’s managed to maintain strong occupancy levels of, at last check, 98.8%. The same was true during the credit crisis and following economic downturn, in which that figure never dropped below 96.6%, which it touched on in 2010.
Similar to OHI and O, WPC has maintained an impressive balance sheet that consists of these healthy credit metrics:
- Pro-rata net debt/adjusted EBITDA of 5.6x
- Total consolidated debt/gross assets of 41.1%
- Weighted average interest rate (pro rata) of 3.2%
- Investment-grade balance sheet with a Baa2 rating from Moody’s and BBB from S&P.
Again, kudos to the management team that’s successfully utilized its two primary advantages – scale and cost of capital – to navigate the current pandemic. It should be no surprise that it’s increased its dividend every year since going public in 1998.
We maintain a Buy rating on this moat-worthy REIT that’s now trading at $64.18. It has a P/FFO multiple of 14.1x and a dividend yield of 6.5%.
Source: FAST Graphs
The power of the moat is directly correlated to “repeatability”: a highly predictable stream of economic profits we refer to as dividends.
The ideal dividend policy varies for each company, of course. But the most successful management teams recognize that their companies’ primary competitive advantages must be utilized to produce consistency through almost any economic cycle.
In a Fortune article from 1999, Warren Buffett explains:
“The key to investing is… determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them ate the ones that deliver rewards to investors.”
For a few last thoughts, here are a few charts powered by iREIT:
Author’s note: Brad Thomas is a Wall Street writer, which means he’s not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: written and distributed only to assist in research while providing a forum for second-level thinking.
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Disclosure: I am/we are long O, WPC, OHI. 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.