On January 28th, Waste Management (“WM”) the publicly traded trash hauler rose approximately 5% in early trading. On that day, there were no earnings announcements pertaining to trash haulers, nor had the company made any public announcement. The apparent reason for the sudden jump in Waste Management’s stock price was a report written by Credit Suisse analyst Hamzah Mazari, suggesting waste companies could qualify for REIT conversion.
Now, we have no opinion on the validity of Mazari’s research or whether or not Waste Management would be willing to convert to a REIT structure. Frankly, we do not have any particular interest in Waste Management. What we do care about is the event that is unfolding in front of our own eyes, the markets insatiable demand for income and the premium valuations that correspond with such demand.
One of the side effects of aggressively low interest rates is investors are forced to reach for yield/income. Low yields on safe government and corporate paper precipitates into low yields on junk bonds, utility stocks, REITS, and MLPs. A rational investor might see inadequately low compensation and choose to step aside, but the stock market is often anything but rational. Instead, investors who are not satisfied with the current levels of compensation being offered simply invest in the next riskiest thing where the “potential” is higher. This path is often pursued until the capital markets line is essentially flat.
Right now the demand for income producing assets is high. Just look at the fanfare Waste Management received from the mere proposition that it could “potentially” qualify for a REIT structure. On the other side of the coin is supply. As market historians know, when a financial product or even attribute is in demand the market will find a way to supply it. As anecdotal evidence, take into consideration the number of REIT conversions that have occurred or will occur in the near future: American Tower Corporation, Corrections Corporation of America, CyrusOne, Equinix Inc., Iron Mountain Inc., Lamar Advertising, Weyerhaeuser, Geo Group Inc., WP Carey Inc. and Ryman Hospitality Properties Inc. If that is not enough look at the record setting number of MLP dropdowns or the record levels of issuance in the junk bond markets.
Corporations’ willingness to convert to REITs and MLPs in mass should tell investors one thing, valuations in these segments of the market are high. We recognize there are benefits to such structures, but the number of willing converters should serve as a red flag. We found an expert from Murray Stahl’s third quarter commentary that aptly summarizes our point.
Typically, the cheapest source of equity capital is the investing public, and due to the hunger for yield, a REIT like Simon Properties, which is by far the largest component of most REIT indexes, can raise equity capital at a cost of only 2.7% (its current dividend yield). This can be quite accretive to earnings, because cash raised can be reinvested in new properties at a higher up-front earnings yield, let’s assume 9%. That serves to increase earnings and the dividend and invite more demand for shares. It can be a virtuous circle for a time. Eventually, though, that funding window closes, for any number of reasons; when it does, the impact upon earnings, the dividend and the valuation multiple can be great indeed. One might ponder the Simon family’s sale, three weeks ago, of $945 million worth of shares. Surely, amongst one’s choice of experts, they must be among the most qualified to assess the merits of those shares.