This article was coproduced with Mark Roussin.

For over a decade now, I have worked within the Real Estate development industry, and one thing that has become abundantly clear is the importance of a strong foundation.

Whether you are building a home, an apartment complex, office building, or a retail center, the difference between a strong or shaky foundation can determine the long-term success and safety of the asset.

The same approach should be utilized when it comes to your portfolio. Those with a risky foundation are feeling quite uneasy right now with the stock market in shambles.

Having positions with higher risk is fine but should not be the focal point of a portfolio. Instead, having a foundation of high-quality stocks to fall back on is the key to an effective long-term portfolio strategy.

There is a lot of uncertainty in the markets right now that are impacting valuations being put on stocks. We have the following:

• Surging inflation;
• Rising interest rates;
• Geopolitical tensions;
• Supply chain constraints.

The list can go on.

All this has seen the markets in a freefall for much of 2022. Although these times can be quite stressful for investors, it can also provide a generational opportunity.

Turning our attention to the REIT sector, the broader REIT industry has been feeling the pain of the market-wide sell-off as well with the Vanguard Real Estate Index Fund (VNQ) down 18% on the year.

As mentioned earlier, the sell-off, especially when it is a broad sell-off, can provide opportunities in high-quality stocks.

In today’s piece, we will not only look at three REITs trading at solid valuations, but I consider these REITs to be Foundational REITs, for which you can count on over the long-term.

Foundational REIT #1: Realty Income Corporation (O)

Out of the gate we begin with not only one of the most popular and well-known REITs in the market today, but quite possibly the greatest REIT of all-time. (I recently added this stock to my grandson’s new REIT portfolio).

Realty Income is a net lease REIT that was founded in 1969 and went public in 1994. The company owns a strong portfolio, with over 11,000 properties in all 50 states and some scattered throughout western Europe.

Known for paying a monthly dividend, the company coined themselves “The Monthly Dividend Company.” O is one of the few REITs on the prestigious Dividend Aristocrats list due in part to the company paying an increasing dividend for 28 consecutive years.

The company has declared over 620 consecutive monthly dividends and increased the dividend for 98 consecutive quarters.

In terms of the portfolio, O has a very diversified portfolio of tenants and long-term leases that allow investors to better forecast future cash flows. The average initial lease term for the company is roughly 15 years with the current average remaining lease term being 9 years.

The company’s portfolio consists of over 1,000 customers in 60 different industries. Here is a look at the company’s top 20 tenants by annual base rent.

As you can see from the top 20 list above, the company has a very large exposure to recognizable and investment grade companies, which only add to the safety of the portfolio.

Here is a look at how the portfolio shakes out based on industry diversification:

Looking at the diversification, you can understand the safety in the event of an economic downturn that is seeing more and more likely in the near future. Grocery stores, convenience stores, dollar stores all scream safety if we are hit with a recession, as all three sectors are sought out by consumers especially in slower economic times.

Areas of concern do revolve around the company’s 4.6% exposure to health and fitness facilities and its 3.3% exposure to movie theaters, two areas hit extremely hard during the pandemic.

The company has taken steps to lower its exposure, but at the same time, both of these property types, at least from what I have seen in my area and cities I visit, people seem more comfortable returning to gyms and movie theaters.

There is no question the negative impact that the pandemic had on businesses across the globe. However, Realty Income still managed to grow AFFO, which was quite rare for net lease REITs given that only three total REITs accomplished this.

The REIT is about as stable as they come, having generated positive earnings growth in 25 out of its 26 years as a public company. Also, the company has seen 5.1% median AFFO growth since 1996.

On top of all that, a strong portfolio with reliable (growing) results, the company has maintained a Fortress Balance Sheet. This has really been one of the key components as to why Realty Income has separated itself from other net lease REITs making it a foundational REIT to consider for your portfolio.

As you can see, O has a credit rating of A3 by Moody’s and A- by S&P. This balance sheet has allowed the company to obtain favorable credit in order to finance acquisitions to grow the business. Strong financing is critical in the REIT space due to the fact REITs are required to pay out 90% of their taxable income to shareholders in the form of dividends every year.

In terms of valuation, shares of O have traded closer to a AFFO multiple of 20x over the past five years. Currently, shares are down 5% on the year and the AFFO valuation multiple stands at 18.5x.

Currently, 15 analysts are forecasting AFFO growth of 8.64% in 2022 followed by 4.23% growth in 2023. The current dividend yield stands at 4.32% with a payout ratio of ~75%, signaling to investors that the dividend is plenty covered.

Here at iREIT on Alpha, we maintain a BUY rating on shares of O with a 12-month total return target of 20%

Foundational REIT #2: Simon Property Group, Inc. (SPG)

The second foundational REIT happens to be the largest mall landlord in the US and that is Simon Property Group. You may be asking why I am including a mall REIT as a “Foundational” position, considering the mall industry is a dying breed. (I recently added this stock to my grandson’s new REIT portfolio)

If that is your thought process, well then you are not far off. However, not all malls are created equal, especially when it comes to a Simon Property Group mall. SPG is the most well-run mall REIT around. Not only do they own the most mall properties but they own the best mall properties.

SPG has a portfolio with an interest in 199 income-producing properties in the US, which consists of 95 malls, 69 Premium Outlets, 14 Mills, six lifestyle centers, and 15 other retail properties in 37 states and Puerto Rico.

At the end of 2020, Simon Property Group closed its muddy acquisition of Taubman Realty Group (“TCO”). I call the acquisition muddy because it was originally announced prior to the pandemic, but once the pandemic hit, TCO was hit rather hard like many other businesses, and that led to SPG getting cold feet. SPG still wanted the assets, but at a much lower price.

The two companies came to an agreement in which SPG ended up paying $3.4 billion for an 80% ownership in the company (saved ~~1 billion off the original purchase price). The TCO portfolio has an interest in 24 regional, super-regional, and outlet malls in the U.S. and Asia.

Internationally the company has ownership interests in 33 Premium Outlets and Designer Outlet properties primarily located in Asia, Europe, and Canada.

In terms of NOI, the portfolio as a whole is made up of 72% US Malls & Premium Outlets, 11% The Mills, 9% International, and 8% other assets.

Here is a look at the company’s top tenants, both inline store tenants and anchors:

Similar to Realty Income, SPG also sports a fortress balance sheet which has credit ratings of A3 from Moody’s and A- from S&P. This is a major advantage for the company and one reason why they dominate the sector with the highest rated portfolio.

Shares of SPG currently pay a dividend of $7.50 per share, which equates to a dividend yield of roughly 5.6%. The payout ratio is 58% (based on FFO).

In terms of valuation, shares of SPG trade at a P/AFFO multiple of ~10x compared to a 5-year average closer to 15x.

SPG is a very well-run company led by CEO David Simon. Here at iREIT on Alpha, we forecast SPG to return 20%+ over the next 12 months.

Foundational REIT #3: Digital Realty Trust, Inc. (DLR)

Next, we will turn our attention to one of the leading data-center REITs in the US with Digital Realty Trust. DLR boasts the largest global data-center footprint, with over 180,000 cross-connects in critical locations, and they partner with over 4,000 customers.

A lot of investors over the past few years have been drawn to technology and the advancements in the sector many companies have made in such a short period. Well, much of that ties back to the need for data centers, which all circles back to a company like Digital Realty Trust.

Although DLR is one of the main players in the data-center space, they do have plenty of competition, with the likes of Equinix (EQIX) being the largest. Other data-center REITs included CyrusOne and CoreSite, both of which were acquired in the past 12 months.

Big Tech is also lurking in the space with the likes of Microsoft (MSFT) and Amazon (AMZN) both having a substantial data center presence of their own.

The runway of opportunity is quite long for a company like DLR given the continued focus by numerous industries to shift to more of a digitalization or cloud focus, especially with many businesses offering work from home options. Companies are looking to not only become more efficient, but also not miss a beat when an employee chooses to work remote.

In the slide below, you can see how this shift continues to take shape, as bookings and rent continue to rise.

Allied Market Research conducted a study in which they concluded that the global data center market is expected to increase from $187B in 2020 to $517B in 2030.

“The shift in traditional on-premises physical servers to the virtual network-based data center, owing to the advancement in multi-cloud computing, is driving the growth of data centers globally.”

Looking at the company’s balance sheet, much of DLR’s debt has a fixed rate, as the company has a weighted average rate of only 2.2%. The company has a shareholder friendly net debt to adjusted EBITDA of 5.9x.

DLR pays an annual dividend of $4.88 which equates to a dividend yield of 3.8%. The company has increased the dividend for 17 consecutive years with a 5-year dividend growth rate of 5.65%.

Shares of DLR have cratered nearly 30% on the year and now trade below $130 after trading as high as $178 at the start of the year. The current share price equates to a P/AFFO of 20.3x, which is actually in-line with where shares have traded the past five years.

Currently, 17 analysts covering the stock are expecting AFFO growth of 4% in 2022 followed by 7.5% AFFO growth in 2023 and 2024.

As viewed above, our 12-month model has shares of DLR returning 12% on a conservative forecast and closer to 25% on a slightly more aggressive forecast.

(Note: I will be adding this pick to my grandson’s new REIT portfolio)

Build a Brick House REIT Portfolio

As most of my readers know, I maintain a conservative-leaning focus because over the years I have learned that chasing yield and/or market timing is simply dangerous.

All of our research at iREIT on Alpha is predicated on making sound financial decisions utilizing risk management tools that are based on fundamental analysis.

Over the years, while writing on Seeking Alpha, Forbes, The Street, and Motley Fool, I have learned that not all people in the stock market are investors.

Benjamin Graham believed that it was critical for people to determine whether they were investors or speculators. The difference is simple:

An investor looks at a stock as part of a business and the stockholder as the owner of the business, while the speculator views himself as playing with expensive pieces of paper, with no intrinsic value.

Ben Graham’s star student, Warren Buffett, said,

“Never invest in a business you cannot understand.”

Thus, understanding the business is the key. Let your investment approach be disciplined and consistent, because ultimately long-term value investors require patience and confidence to be successful.