Most investors understand the fundamentals of the business cycle. For the uninitiated, the business cycle follows the economy through four distinct stages: expansion, peak, contraction, and trough.
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While most understand the four stages, too few investors give thought to what investments perform best in any particular stage of the economy. For example, most everyone understands that growth stocks are the best investment in a rapidly expanding economy.
But as the economy hits a peak, difficult decisions need to be made. Continuing to hold equities at a peak can cause significant losses (called a drawdown) should the economy roll over into recession.
Caution, Peak Ahead
This is where many investors make a huge mistake. They opt for bonds for their relative safety and income. In return, they do significant harm to their portfolios.
You see, just because the economy appears to be at a peak, that doesn't mean the economy can't continue higher. Technical investors call this period a consolidation -- and yes, economies consolidate just like equities.
Should the economy resume expanding, bond investors will see significant drawdowns in their portfolios because bond prices are inverse to interest rates. And in an expanding economy, interest rates are rising, which means bond prices are falling. Investors looking for safety and income are getting the income at the expense of huge portfolio drawdowns.
Instead, investors should get conservative in their portfolio management at this important juncture. By doing so, they will be ready to buy equities should the economy consolidate, or jump on bonds when interest rates start falling as the Fed goes into recession fighting mode.
But all this begs the question: What should investors do at an apparent peak?
Investors have several options. First, they can move to money market instruments like T-Bills, repos, or commercial paper to wait out the sideways market movement of a peaking economy. But doing so comes with little in the way of investment returns – after all, the returns on money market instruments are abysmal.
Another approach is to look for alternatives -- like buying ground leases. Ground leases are used by a landowner to lease their land to a tenant on a long-term lease (up to 99 years), who then develops the land and operates a business on it. At the end of the lease, the landowner retains ownership of the land and all improvements.
Ground leases are actually safer than most money market instruments as the leases are senior to other lease obligations, including mortgage bonds securing the improvements. Better yet, should a tenant abandon a lease, the landowner owns the land and any improvements made by the tenant.
For investors looking for safe real estate investment trust (REIT) income, the first publicly-traded company formed to acquire, own, manage, finance and capitalize ground leases is Safety, Income & Growth (NASDAQ: SAFE).
The New York-based company targets major markets throughout the U.S. in generating higher returns for owners of high-quality multifamily, office, industrial, and hospitality properties ranging from $25 million to $1 billion. And due to the nature of the leases, they do so with less risk than other REITs.
Solid Results YTD
As of September 2018, the company's inventory of leased property included 26 properties, with three additional properties in various stages of development in San Jose, Washington D.C., and Nashville. The current market value of its real estate holdings is about $413 million.
Through the first nine months of 2018, the company's revenue grew to $32.7 million. The company reported net income of $7.5 million during this time. And because SAFE is a REIT, at least 90% of its taxable income is required to be distributed to shareholders. Based on current inventory, the company pays a $0.15 quarterly dividend, and yields 3.12% at current prices.
Shares of SAFE remain above the average analyst 12-month target price of $18.80. Of course, a stock holding its ground against a price target is a bullish indicator -- especially for a stock trading at a 7% discount to its book value of $20.23.
To Peak Or Not
Major market indices have seen significant volatility in recent weeks. The CBOE volatility index (^VIX), at 23, remains significantly higher than its historic average. A high VIX in combination with the very real possibility of an inverted yield curve, where rates on short bonds are higher than on long-term issues, means investors need to be cautious here. Safety is more important than profits, and shares of SAFE meet this requirement.
Risks To Consider: Safety, Income & Growth is a microcap stock with a market cap of just $360 million. On top of that, the stock only started trading publicly in June 2017, so there's not a lot of history to compare. Of course, both of these facts means the company is thinly traded and potential illiquid should another financial crisis arise.
Action To Take: Buy shares up to $19.50 per share. Mitigate risk by applying no more than 2% of your portfolio to shares of SAFE. Use a $15 hard stop to protect your capital. Expect to hold shares of SAFE for no more than 1 – 2 years.