Does investing in businesses carry risk?
Sure.
Everything in life has risk.
Life itself is a risk, as we’re all slowly marching to the end.
Moreover, I’d actually argue that not taking risk is the biggest risk of all.
Avoiding investing out of an irrational fear of risk might just be the most expensive thing one could ever do with their money.
That’s because it means one misses out on the immense power of compounding.
Compounding causes exponential growth of money.
A compound annual growth rate of 10% – the long-term average of the broader US stock market – doubles one’s money every seven years!
What’s even more amazing is that one could do better than the broader market and that 10% mark.
How?
By applying the dividend growth investing strategy.
This is a long-term investment strategy that involves buying and holding shares in world-class businesses that reward shareholders with reliable, rising cash dividend payments.
And reliable, rising profit is difficult to achieve without running a great business.
As you can see, this strategy tends to funnel an investor almost automatically right into great businesses.
You can see many examples of these great businesses by looking over the Dividend Champions, Contenders, and Challengers list.
This list has hundreds of US-listed stocks that have raised dividends each year for at least the last five consecutive years.
I’ve been using this strategy for nearly 15 years now.
It’s the foundation upon which my FIRE Fund is built.
That’s my real-money portfolio, and it generates enough five-figure passive dividend income for me to live off of.
Living off of passive dividend income is a neat trick, and it’s one I’ve been able to pull off ever since I quit my job and retired in my early 30s.
Now, the dividend growth investing strategy is about more than simply investing in great businesses.
There’s also the matter of valuation.
See, price only tells you what you pay, but it’s value that tells you what you get.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.
Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.
And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.
These dynamics should reduce risk.
Undervaluation introduces a margin of safety.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.
It’s protection against the possible downside.
Buying high-quality dividend growth stocks when they’re undervalued is a calculated way to take risk, participate in the incredibly powerful process of compounding, build significant wealth and passive income, and even possibly become financially free.
Of course, the whole concept of valuation is much more helpful when one understands it.
That’s where Lesson 11: Valuation comes in.
Put together by fellow contributor Dave Van Knapp, it explains valuation in simple-to-understand terms and even provides a valuation template that can be applied to almost any dividend growth stock out there.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
Invitation Homes Inc. (INVH) is a real estate investment trust that owns and operates single-family homes for lease across the United States.
Founded in 2012, Invitation Homes is now a $21 billion (by market cap) real estate titan that employs roughly 1,500 people.
Invitation Homes offers approximately 85,000 homes for lease across more than 20 US markets.
The company’s property portfolio is primarily focused on the Western US (40% of revenue), but Florida (32%), the Southeast US (18%), and Texas (6%) are also major areas of exposure.
This is a simple business model with a straightforward proposition: Invitation Homes aims to own and operate high-quality homes in desirable neighborhoods which feature convenient access to employment hubs, top schools, and transportation networks.
That’s it.
And what more could there be?
A good home in a desirable, convenient neighborhood is what most American families want.
It’s part of the “American Dream”.
Unfortunately, the ability to actually own a piece of that dream has become very difficult.
Homeownership in the US has rarely been more expensive than it is now.
A lot of this comes down to a shortage of housing supply.
The US is currently short an estimated four to seven million homes.
Due to many challenges with bringing housing to market, many of which date back to the great financial crisis, US housing supply has not kept up with demand for more than a decade.
The pandemic exacerbated the situation, adding to the supply shortage – making a recovery in supply more elusive.
It’ll take several years of consistent building (averaging ~1.4 million new builds per year) to simply catch up with today’s demand, let alone the steady rise in demand (because of new household formation) that’s steadily occurring every single year in the interim.
It’s a moving target that seems almost impossible to hit.
Well, Invitation Homes offers a solution to would-be homeowners – and an exciting proposition to investors.
The company offers spacious (averaging about 1,900 square feet) homes for rent in great neighborhoods across some of the most sought-after areas of the US (including the Sunbelt).
If a family wants a home but cannot afford to buy (because of the aforementioned dynamics leading to high prices on existing supply), a home that’s easy to move into and immediately lease at an affordable monthly payment is the next best thing.
Shelter is a basic need with enduring demand.
And having that shelter take the form of a home in a nice, clean, safe, convenient neighborhood is something that has timeless, ceaseless appeal.
Look, if one cannot own a piece of the “American Dream”, renting a piece of it is a reasonable alternative.
And this is why Invitation Homes might just have the best business model in the entire REIT space.
It’s also why its revenue, profit, and dividend continue to grow like clockwork.
Dividend Growth, Growth Rate, Payout Ratio and Yield
To date, the company has increased its dividend for eight consecutive years.
Seeing as how Invitation Homes had its IPO in 2017, its dividend growth track record is as long as it possibly could be.
Said another way, Invitation Homes has been paying and growing the dividend right out of the gate.
The five-year dividend growth rate of 18.8% is shockingly high for a REIT – an investment vehicle more known for income than growth.
In fact, I’d say that anything more than mid-single-digit growth out of a REIT is kind of unusual.
However, we have to keep in mind that Invitation Homes had a chance to expand the payout ratio from a 0% level on a post-IPO basis.
Still, the most recent dividend raise was 7.7% – more indicative of where the dividend growth trajectory is currently at.
That’s not bad at all.
High-single-digit dividend growth from a REIT stands out in a good way.
And you’re pairing that with the stock’s market-beating yield of 3.2%.
While that might be on the lower end of what you might see in REITdom, it’s actually a full 100 basis points higher than its own five-year average (with the caveat being that the average is skewed downward by the fact that the yield was so low and aggressively growing out of the IPO).
With a payout ratio of 60%, based on FY 2024 core FFO/share, this is one of the healthiest and safest dividends I know of in this space (because high payouts are a feature, not a bug, among REITs).
For dividend growth investors looking for a REIT with unusually fast growth (at the expense of some yield), all backed by a basic need with enduring demand, Invitation Homes has some pretty compelling dividend metrics.
Revenue and Earnings Growth
As compelling as these metrics may be, though, many of them are based on what’s happened in the past.
However, investors must always be thinking about what is likely to happen in the future, as the capital of today gets risked for the rewards of tomorrow.
That’s why I’ll now build out a forward-looking growth trajectory for the business, which will be of use when the time comes to estimate fair value.
I’ll first show you what the business has done over the last decade in terms of its top-line and bottom-line growth.
And I’ll then reveal a professional prognostication for near-term profit growth.
Lining up the proven past with a future forecast in this manner should give us what we need to make a judgment call on where the business could be going from here.
Invitation Homes advanced its revenue from $1.1 billion in FY 2017 to $2.4 billion in FY 2023.
That’s a compound annual growth rate of 13.9%.
I usually use a decade’s worth of growth (using that as a proxy for the long term), but Invitation Homes only has a public history dating back to its 2017 IPO.
This number continues the theme of unusual and impressive growth for this REIT.
But it is also somewhat misleading.
When it comes to REITs, it’s imperative to look at profit growth on a per-share basis.
That’s because REITs use debt and equity to fund growth, as they’re legally required to distribute at least 90% of their taxable earnings to shareholders.
This circles back around to the point I made earlier on REITs being known as income plays.
Because of the legal structure that forces payouts, limitations around internal funding for growth means tapping equity (by issuing shares) and diluting shareholders.
Thus, you see common distortions between absolute revenue growth and profit growth relative to shares outstanding.
Also, when assessing profit for a REIT, we want to use funds from operations instead of normal earnings.
FFO (or adjusted FFO) is a measure of cash generated by a REIT, which adds depreciation and amortization expenses back to earnings.
Invitation Homes increased its FFO/share from $0.50 to $1.64 over this period, which is a CAGR of 21.9%.
Not only is the bottom-line growth here far higher than what many other REITs offer but there’s also been accretion.
This is rare.
It’s often the opposite for REITs (many have lower per-share growth than absolute top-line growth).
Remarkable.
And we can now see that exceptional dividend growth has been justified by exceptional bottom-line growth, not just fueled by a pure expansion of the payout ratio.
Looking forward, CFRA currently has no three-year forecast for the REIT’s FFO/share growth.
That’s unfortunate, but CFRA seems to lack these forecasts when it comes to REITs for some reason.
That said, this passage from CFRA speaks volumes about the value proposition and investment thesis for this REIT: “[Invitation Homes] operates in markets with strong demand drivers, high barriers to entry, and high rent growth potential, primarily in the Western United States, Florida, and the Southeast United States. Through disciplined market and asset selection, the trust has a single-family home portfolio to capture the operating benefits of local density as well as economies of scale that cannot be readily replicated. Management targets markets that they expect will exhibit lower new supply, stronger job, and household formation growth, and superior NOI growth relative to the broader U.S. housing and rental market.”
That sums it up well.
If one believes that families will want access to affordable housing options in attractive US markets, Invitation Homes basically can’t lose.
Since CFRA has no forecast, we can use the recent numbers to build a trajectory.
For Q2 FY 2024 (its most recent quarter), Invitation Homes generated 8.8% YOY revenue growth and 7.3% YOY core FFO/share growth.
Management is guiding for $1.87 in core FFO/share, at the midpoint, for FY 2024.
This would represent 5.6% YOY growth on this metric.
So there’s clearly a slowdown from lofty levels, which isn’t surprising.
It would be unrealistic to expect indefinite 20% growth out of a REIT.
Still, the most recent quarter showed high-single-digit top-line and bottom-line growth.
And the most recent dividend raise was nearly 8%.
If one can get a 3%+ yield and high-single-digit growth, that sets one up for a 10%+ annualized total return out of this business – all based on a simple-to-understand business model with built-in demand and no visible risk of obsolescence.
Tough to complain about that.
Financial Position
Moving over to the balance sheet, has a relatively okay financial position.
The net debt/equity ratio is 0.8.
The company ended FY 2023 with total net debt of $8.6 billion, which isn’t overly concerning for a market cap of $21 billion.
I’ll note that Invitation Homes has no debt reaching final maturity until 2026.
A common measure for a REIT’s financial position is the debt/EBITDA ratio, and I usually see REITs range from 3 to 7 on this ratio (lower is better).
Invitation Homes has a net debt/EBITDAre ratio of 5.5.
Right up the middle.
The REIT structure encourages debt (because much of the cash flow gets returned to shareholders via large dividends), so it’s unsurprising to see Invitation Homes employing quite a bit of leverage.
And because leveraged balance sheets are so commonplace across this space, I’m personally not a huge fan of REITs.
However, if there’s one type of commercial real estate that I am extremely enthusiastic about over the long term, it’s shelter.
People will always need somewhere to live, and most families prefer the form factor of a single-family detached home (but cannot always afford to buy one).
Plus, it’s hard to imagine any kind of future in which shelter becomes obsolete (which cannot always be said about other types of commercial real estate).
That kind of long-term visibility into demand really does calm my balance sheet concerns when it comes to this particular REIT.
Overall, with a structural shortage of homes in the US, which makes rental alternatives more attractive, and with SFHs for rent in appealing locations across the country, Invitation Homes is in the right place(s) at the right time.
And with economies of scale, an entrenched footprint in desirable locations, and favorable supply dynamics that feed demand, the company does benefit from durable competitive advantages.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
Although direct competition is limited, homes for purchase will always compete for the company’s rental SFHs.
On the regulatory front, regulations across the housing industry actually act as a tailwind (because supply continues to be restricted).
On the other hand, a recent $48 million fine by the FTC (for deceptive practices) is a regulatory bite that also implies poor control and damages the firm’s reputation.
A REIT’s capital structure relies on external funding for growth, which exposes the company to volatile capital markets (through equity issuances) and interest rates (through debt issuances).
Adding to the rate conversation, elevated rates (though currently dropping) can hurt this particular business model twice over: Debt becomes more expensive to take on and service, and equity can become more expensive (because income-sensitive investors have alternatives, which puts downward pressure on the stock price).
While Invitation Homes has leadership and scale, there are no unsurmountable barriers to entry that prevent competitors from replicating the business model by acquiring land and building homes.
The US continues to slowly build supply add houses to inventory, and more homes for sale could reduce demand for rental homes.
Multifamily housing REITs have demonstrated long-term success in the market, but single-family homes for lease at scale is a business model that doesn’t have the same kind of proven track record.
There is some exposure to the economy, as rising unemployment in the company’s key markets would likely lead to less demand, lower rents, and higher vacancies.
Since Invitation Homes must buy homes to grow its portfolio, the company is directly exposed to the US housing market (which can be quite volatile, even at local levels).
Many of these risks are not specific to Invitation Homes and can be ascribed to any REIT, even though this is a special REIT in some ways.
The valuation also appears to be pretty standard, not pricing in very much exceptionalism…
Valuation
The forward P/FFO ratio is 18.4, based on midpoint guidance for this year’s core FFO/share.
That’s somewhat analogous to a P/E ratio on a normal stock.
This is not demanding.
If anything, it’s actually on the low side for a REIT.
The cash flow multiple of 19.7 is lower than its own five-year average of 21.8.
And the yield, as noted earlier, is significantly higher than its own recent historical average.
So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis.
I factored in a 10% discount rate and a long-term dividend growth rate of 7%.
This growth rate is admittedly on the high end of what I normally allow for when working with a REIT.
But I’m only allowing for it because Invitation Homes has proven itself capable of growing faster than most other REITs.
When the growth rate is faster, I adjust the model.
If there’s a thread that’s been running throughout today’s piece, it’s that Invitation Homes seems to be growing its FFO/share and dividend at a high-single-digit rate.
The most recent dividend raise, which I think is a pretty good baseline for a future expectation, came in at nearly 8%.
I don’t see Invitation Homes growing the dividend at a rate well in excess of 7% over the long run.
Equally so, I’d be surprised if the dividend grows far slower than 7% annually.
The DDM analysis gives me a fair value of $39.95.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.
The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.
I find it to be a fairly accurate way to value dividend growth stocks.
Although I wouldn’t call it “dirt cheap”, the stock does look undervalued to me.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.
1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates INVH as a 4-star stock, with a fair value estimate of $41.00.
CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.
They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
CFRA rates INVH as a 3-star “HOLD”, with a 12-month target price of $38.00.
I’m almost squarely in the middle on this one. Averaging the three numbers out gives us a final valuation of $39.65, which would indicate the stock is possibly 13% undervalued.
-Jason Fieber
Note from D&I: How safe is INVH’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 60. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, INVH’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.
P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.
Disclosure: I’m long INVH.
