The Ground Up: REITs With The Best Mousetraps

It’s funny, most analysts write and talk about innovation as the “death nail” for commercial real estate. Especially in the retail sector where Amazon has been like Darth Vader of sorts, virtually disrupting the world of brick and mortar by luring shoppers away from Malls and into iPads and iPhones.

That’s also happening in the Lodging sector these days, as Airbnb is attempting to disrupt the lodging sector by persuading travelers to book cozy cottages instead of costlier limited or full service hotel rooms.

Although technology has certainly become a powerfully disruptive force in commercial real estate, many real estate investment trusts (or REITs) are using it to their advantage to add value. It’s almost a must for any organization to adapt to the rapid changes of technology and I have found that some of the best REITs are differentiated by their innovative approach to value creation.

As Braden Kelley, author of the five-star book Stoking Your Innovation Bonfire, explains, “some authors talk about successful innovation being the sum of idea plus execution, others talk about the importance of insight and its role in driving the creation of ideas that will be meaningful to customers, and even fewer about the role of inspiration in uncovering potential insight. But innovation is all about value and each of the definitions, frameworks, and models out there only tell part of the story of successful innovation.” One of Kelley’s favorite examples of “useful versus valuable” is the mousetrap. He writes,

Despite the hundreds or thousands of patent applications submitted every year for new mousetrap designs, most people still purchase the same simple snapping mousetrap that you see in cartoons and that has been around for a hundred years. The mousetrap is a great example of how easy it is to generate innovation investment opportunities and how difficult it is to create something that is truly valuable.

Kelley adds that the true “distinction between useful and valuable is one that you must seek to understand and by turning this into a lens through which you can look at the potential of your innovation investment opportunities, the higher the return you will have from your innovation portfolio.”

REITs With The Best Innovation Mousetraps

Alexandria Real Estate Equities (ARE) develops urban cluster campuses and vibrant ecosystems that enable and inspire the world’s most brilliant minds and innovative companies to create life-changing scientific and technological breakthroughs. ARE is a landlord to many leading life science companies and leading academic universities across the US with a major focus on gateway markets such as Seattle, San Francisco, San Diego, New York, Boston, and Maryland. More recently ARE has expanded into technology (closely aligned with life science) to develop campuses such as the new Uber headquarter (423,000 square feet) in San Francisco.

ARE’s successful “mousetrap” has generated around 25% annual FFO (or funds from operations) growth over the last few years, resulting in stellar Total Return performance: 844% since the company’s IPO in May 1997 (double that of Wal-Mart and Berkshire Hathaway ). Shares are now trading at $78.30 with a P/FFO (price to funds from operations) multiple of 14.9x. There seems to be cheese in the mousetrap as ARE has pulled back around 15% over the last 30 days and the dividend yield is now slightly under 4%.

Extra Space Storage (EXR) is another leading REIT innovator that deserves a special mention. In fact, I view EXR as more of a technology landlord than a real estate landlord. Think about like this? What’s the last time you rented a storage unit and how did you find the building? If you tell me that it was the yellow pages then you must still be using a rotary phone at home.

EXR has invested significantly in a powerful leasing and revenue management platform that boasts 109 total employees dedicated to internet marketing. Within the massive data funnel EXR continuously optimizes SEO to lease up 1,335 properties and over 37,700 individual storage units. The company can easily double its portfolio size which means that it can also double its customer base from around 800,000 to over 1.5 million.

There are several other self-storage REITs but EXR has proven that it has the best mousetrap, easily beating the others on virtually all metrics: same store NOI growth, occupancy growth, and AFFO growth (was 17.1% in 2015). The valuation is high (based on real estate fundamentals) as P/FFO is 30.0x and the dividend yield is just 2.7%. However, the potential for growth is extreme and that’s why the shares have priced in for the ride – I’m glad I got in early as EXR was my best REIT pick in 2015 (I would wait on a pullback to establish a position today).

Welltower Inc. (HCN) is a leading healthcare REIT with a Total Capitalization of around $37 billion. While most health care REITs are focused on securing well-located medical assets, HCN has taken its business strategy to another level – investing in state of the art facilities designed to embody the goals of the corporation by creating a comfortable workplace conducive to creative thinking and collaboration.

As I have researched HCN (see my latest paper here) I have concluded that this company is more focused on developing deep relationships in wellness first, and being a real estate landlord second. By investing alongside the top medical providers, HCN believes it can become the conduit for healthcare, much like Amazon is in the retail world.

Since health care systems are the center of the payment fulfillment process, HCN has responded by focusing on outpatient delivery and investing in outpatient infrastructure, also a high margin business.

Again, HCN’s mousetrap has produced outsized results: The payout ratio has been substantially reduced (it’s around 75% today) while the dividend growth record has increased - HCN has generated steady and reliable dividend performance for over 44 years in a row (CAGR over that period is 5.1%). Shares are trading at $67.75 with a dividend yield of 4.9%. I find the valuation attractive (P/FFO multiple is 15.5x) given the highly defensive attributes as well as the disciplined risk control attributes.

To Sum It Up: Innovation plays a critical role in any organization and new value can be created by “making something more efficient, more effective, possible that wasn’t possible before”. As Braden Kelley suggests, if it’s “done really well, value translation also helps to communicate how easy it will be for customers and consumers to exchange their old solution for the new solution.” As a real estate analyst, I will always see value in land and buildings – remember there not making it anymore – but I’ll also side with the tech writers “because innovation is all about value.”

Disclosure: I own shares in EXR and HCN. 

Brad Thomas is editor of Forbes Real Estate Investor and writes for Forbes.com and Seeking Alpha. He is also a frequent guest on Fox Business and he is currently writing a book, The Trump Factor, about presidential candidate Donald J. Trump.