DDR Corp (DDR), EPR Properties (EPR), Digital Realty Trust, Inc. (DLR): Trading the Rise in Interest Rates; More Pain Ahead for REITs

In early May, hedge fund analyst Jonathon Jacobson of Highfields Capital Management outlined a short thesis on the name at the Ira Sohn Conference. He argued that Digital Realty Trust, Inc. (NYSE:DLR) is worth around $20 per share (implying roughly 65% downside from current levels) and that the company is paying dividends using debt issuances instead of free cash flow.

Jacobson also noted that data center rents have fallen around 20% since 2006 and the storage market faces stiff competition from cloud computing companies like Google, Amazon.com and Microsoft. These trends can be seen in analysts’ estimates for Digital Realty Trust, Inc. (NYSE:DLR). Over the last 5 years, the REIT has grown earnings by around 44% per year, but for the next 5 years, growth is only expected to be around 9% per annum.

When looking through the rear-view mirror, Digital Realty Trust, Inc. (NYSE:DLR) still looks attractive. The stock yields over 5% and both annual revenue and FFO have shown consistent growth over the last 5 years. On a quarterly basis, however, net income has been down for the last three reporting periods and margins are also falling.

Rich Vvluation for National Retail

National Retail Properties, Inc. (NYSE:NNN) is another REIT that may be in trouble based on short interest and trading trends. Despite being up around 3% in 2013, National Retail has lost roughly 17% over the last month amid panic selling. The company focuses on long-term net leases, which makes it especially vulnerable to rising interest rates. Investors are betting that the REIT’s current yield of just under 5% is still too low to attract new capital as the risk-free rate rises.

The company has historically been a standout in the sector. National Retail Properties owns 1,636 free-standing restaurants, shops and other buildings and has raised its annual dividend for 23 consecutive years. Nevertheless, its short interest of over 10% suggests that investors expect the share price to continue to fall.

Despite the losses in the name, National Retail Properties, Inc. (NYSE:NNN) continues to trade at a rich valuation which may be hard to justify if rates keep rising. Currently, NNN is trading at more than 18 times this year’s FFO estimates. Given that analysts are only modeling bottom-line growth of 2.90% per year for the next 5 years, the REIT would appear to be overvalued despite the company’s strong track record.

Bottom line

There are significant signs that the bond market has reached an inflection point and that interest rates will continue to rise. If the long-term cycle of lower rates is indeed over, the magnitude of this shift could be enormous. Investors looking to make a directional bet on higher rates, or to hedge against continued market volatility, should consider scanning the REIT sector for high probability short opportunities.

Although many of these securities have already recorded steep losses in recent weeks, history suggests that this trade is still in the early innings. Years and years of Federal Reserve bond-buying has driven Treasury yields to irrational levels. As this bubble continues to burst, investors should prepare for more carnage in the REIT sector.

The article Trading the Rise in Interest Rates; More Pain Ahead for REITs originally appeared on Fool.com and is written by Ryan Glosier.

Ryan Glosier has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Ryan is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.

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