REIT Rankings: Cell Towers
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Cell Tower Sector Overview
Cell tower REITs comprise roughly 10% of the REIT ETFs (VNQ and IYR). Within the Hoya Capital Cell Tower REIT Index, we track the three cell tower REITs which account for roughly $160 billion in market value: American Tower (AMT), Crown Castle (CCI), and SBA Communications (SBAC). Cell tower REITs are on the “growth” side of the real estate spectrum and generally pay a low dividend yield but have achieved some of the highest internal and external growth rates across the real estate sector over the past decade. Investors seeking focused but diversified exposure to this sector should consider the Benchmark Data & Infrastructure Real Estate ETF (SRVR).
More than any other real estate sector, cell tower ownership is highly concentrated. Cell tower REITs own roughly 50-80% of the 100-150k investment-grade macro cell towers in the United States. For this reason, while cell towers may constitute only a tiny portion of total real estate asset value in the United States, they constitute a disproportionally high importance in the market capitalization-weighted investible real estate indexes and in fact, American Tower and Crown Castle are the two single largest REITs. Strong performance from cell tower REITs over the past two years have explained much of the underperformance of the traditional “core” real estate sectors.
Consumers want both speed and mobility, but because of the physics and economics of data transmission, there is often a tradeoff between the two. For pure speed and low-latency, a robust fiber-based or dense 5G small-cell network is ideal. This requires laying thousands of miles of underground cables and/or having hundreds of thousands of small-cell base stations using high-band spectrum. For pure mobility, a wide-reaching macro cellular network using high-powered transmitters at lower and farther-reaching spectrum is ideal. This requires having a network of macro towers, but each tower is capable of servicing tens of thousands of devices each, rather than several dozen or hundreds of customer per small-cell antenna.
Since consumers need both speed and mobility and none of the players are able to fully satisfy both of these needs, a blend of different technologies- including macro cell networks- will continue to be used to meet the growing demand for data connectivity. It’s important to note that both AMT and SBAC have significant international operations, while CCI is a pure-play US operator. AMT and SBAC focus on the macro tower business, while CCI has made significant investments in fiber and small-cell networks in addition to their primary tower business.
Bull & Bear Thesis for Cell Tower REITs
Our research continues to indicate that macro cell towers provide the most economical mix of coverage and capacity, and recent challenges with dense small-cell network deployment have affirmed our belief that macro towers will continue to be the “hub” of next-generation networks for the foreseeable future. While communications technology does change very rapidly, it appears that the physical and economic limitations of the alternative technologies (low-orbit satellites, wide-spread small cell networks, and outdoor Wifi) are unlikely to abate anytime soon and the risk of technological obsolescence in the 5G-era is often overstated.
Cell tower REITs continue to command strong competitive positioning in the telecommunications sector. Cell carriers sold off their tower assets beginning in the mid-2000s to de-lever their balance sheet and free-up capital to expand their networks. Supply growth is almost non-existent in the US as there are significant barriers to entry through the local permitting process. The relative scarcity of cell towers, combined with the absolute necessity of these towers for cell networks, has given these REITs substantial pricing power. While cell carriers have tried to make moves to establish leverage over tower owners by building or acquiring towers themselves, carriers have limited available capital to spend on these initiatives, especially in light of the capital-intensive 5G rollout.
The four-year run of strong performance, however, has pushed cell tower REIT valuations to elevated levels compared with the rest of the real estate sector. The land under cell towers, of course, is worth very little without a functioning macro cell site. While we don’t believe there is an immediate risk of technological obsolesce, it is impossible to predict technological innovation in a decade, much less over multiple decades. Further, there are only four major players in the US carrier industry (and potentially three if the Sprint /T-Mobile merger gets approved), limiting the number of potential tenants for these REITs. Carriers are incentivized to invest capital in alternative technologies like small-cells and DAS to try to reduce the competitive position of cell towers. Perhaps the most significant risk relates to the fact that these REITs own just 30% of the land under their structures and lease the other 70% through (typically long-term) ground leases.
Potential Outcomes of Sprint/T-Mobile Deal
The cell tower REIT industry continues to await the outcome of the Sprint/T-Mobile merger, which has the potential to alter the competitive dynamics within the telecommunications space. Earlier this year, the third and fourth largest US wireless carriers announced a long-awaited merger agreement that would consolidate the industry into three nearly-equal competitors along with AT&T (NYSE:T) and Verizon (NYSE:VZ). Following years of discussions and a failed attempt at a merger in 2014 that was blocked by US regulators, the two firms finally came to terms on the potential $26-billion deal. The combined entity would command a roughly 35% share of total retail wireless connections, including 25% of postpaid phone subscribers and nearly 60% of prepaid phone subscribers.
While revenues from Sprint (NYSE:S) and T-Mobile (NASDAQ:TMUS) comprise a combined 26% of total industry revenues, the “overlap” between Sprint and T-Mobile cell tower sites is roughly 4% of total industry revenues. This 4% represents a “worst-case-scenario” in which T-Mobile completely shuts down the Sprint network on redundant towers and does not subsequently need to upgrade their equipment to handle the increased capacity. Crown Castle, which is US-focused, would be most affected, while American Tower, which has a significant international presence, would be relatively unscathed.
Last week, The Wall Street Journal reported that the Department of Justice informed T-Mobile and Sprint that the deal is “unlikely to be approved as currently structured.” The general consensus among analysts is that the odds of approval have now decreased from above 75% late last year to below 50% currently. As we discussed during our last update, we believe that the merger approval will likely hinge on the regulator’s assessment of the likelihood and forecast of four key unknown factors, ranked in order of importance.
|1) Can Sprint survive without a merger?|
|2) Would Sprint have other suitors (cable companies, tech companies)?|
|3) Would a merger help or hurt the growth of 5G?|
|4) Is wireless broadband a competitor to the home broadband providers?|
Given the uncertain answers to these four questions and a wide range of permutations of possible outcomes, analysts are generally split as to whether cell tower REIT investors should be rooting for or against the potential merger. Our assessment is that cell tower REITs would ultimately benefit from a no-deal outcome, but that the downside risk is more significant if Sprint were to indeed fail as a result. We outline our assessment through an analysis of the three possible outcomes.
Scenario 1: Merger Approved
The cellular carrier industry would be consolidated into three players of roughly equal size. With more balance sheet capacity, the merged T-Mobile would likely ramp up network spending in line with Verizon and AT&T, which would translate into an immediate boost to cell tower REIT revenues. With one less competitor, the 5G rollout begins sooner but is focused on higher-value markets and consumer pricing would likely become less competitive, translating into higher margins for carriers, but potentially fueling further network investment. Over time, however, the competitive positioning of cell tower REITs would be diminished. Carrier initiatives to gain leverage over cell tower REITs, including building their own towers or taking over leases from REITs, would be incrementally more successful and growth would moderate but remain at above-inflation levels due to the still-favorable competitive positioning of cell tower REITs.
Probability: 50%. For Cell Tower REITs: Decent/Default Outcome.
Scenario 2: Merger Rejected. Sprint Finds Third-Party Partner
The merger gets rejected, but Sprint’s underpriced and valuable network and spectrum assets are attractive to cable broadband providers (Comcast (NASDAQ:CMCSA), Charter Altice) who recognize the mounting and legitimate threat from 5G fixed wireless broadband, which we believe to be underappreciated by the market. Alternatively, a cash-flush technology company (Amazon (NASDAQ:AMZN), Google (NASDAQ:GOOG) (NASDAQ:GOOGL), or Microsoft (NASDAQ:MSFT)) sees the assets as an underpriced compliment to their existing data center infrastructure and a new source of distribution to mitigate the competitive threats from the incumbent broadband providers. Sprint is able to leverage this partnership to become a legitimate competitor in the space. Meanwhile, T-Mobile continues its strong run of adding customers at sector-leading rates. The carrier industry remains at four players with T-Mobile and Sprint close behind and consumer pricing competition remains intense. The four carriers battle to become leaders in 5G and access is widespread. Initiatives to gain leverage over cell tower REITs are largely unsuccessful and pricing power remains strong.
Probability 35%. For Cell Tower REITs: Best Outcome.
Scenario 3: Merger Rejected. Sprint Fails
The merger gets rejected Sprint is unable to find a suitable partner. Sprint’s investors, including SoftBank (OTCPK:SFTBY), scale back their investment and the network falls further behind the other three carriers and continues to lose customers until being unable to operate any longer. In bankruptcy, Sprint’s assets are distributed around the telecom sector including to AT&T and Verizon, further strengthening their grip on the emerging duopoly. T-Mobile’s strong run of performance slows down and cannot keep up with the network spending of the two major players without the complementary asset of Sprint. The carrier industry becomes a de-facto duopoly and cell tower REIT competitive positioning is significantly diminished. Consumer pricing becomes significantly less competitive and the 5G rollout continues but is isolated only to the most high-margin deployments. Carrier initiatives to gain leverage over tower REITs are largely successful and the industry becomes more akin to the data center REIT sector over the past several years with below-inflation internal growth rates and weak pricing power over increasingly dominant tenants.
Probability 15%. For Cell Tower REITs: Worst Outcome.
Recent Cell Tower REIT Fundamental Performance
2018 was another strong year for the cell tower sector as the early effects of network densification to fuel 5G networks powered above-trend organic growth. Organic tower revenue, effectively the same-store NOI equivalent, continues to grow at a sector-leading 6%+ rate as carriers continue to invest heavily in network densification and equipment upgrades. With the high degree of operating leverage inherent with the co-location tower model, tower REITs are seeing amplified benefits increased network spending.
These REITs are forecasting an average 8% rise in AFFO per share in 2019, among the strongest rates of growth in the real estate sector. Along with robust organic growth, external growth via strategic acquisitions remains a central focus of cell tower REITs, aided by the cost of capital advantage enjoyed by these firms. As we’ll discuss shortly, cell tower REITs trade at an estimated 30-50% premium to private market-implied net asset values, meaning that external acquisitions, though somewhat limited, are easily accretive to earnings.
The combination of strong organic growth and continued external growth fueled a 16% rise in total property revenues in 2018, rising from the 13% rate achieved in 2017, boosted by the effects of Crown Castle’s merger with small-cell operator Lightower. While appearing to be very conservative, these REITs offered guidance that projects a 5% rise in property revenues in 2019.
Carrier Performance & Capital Spending
Cell tower REITs are inexorably linked with the underlying performance of their cell carrier tenants, who delivered another very strong year. AT&T, Verizon, T-Mobile, and Sprint combined to add more than 4.5 million post-paid wireless customers in 2018, a sharp increase from the 3.8 million added in 2017, and the strongest year ever for cell carriers. Pricing remains highly competitive with customers effectively seeing an average 3% drop in their phone bills.
Capital spending by cell carriers is a key driver of growth for tower REITs. Capex among US carriers had been in a lull for the past two years as much of the available capital has been put towards spectrum acquisition which will power the next generation 5G networks. Capital spending is expected to ramp up again as carriers begin to deploy 5G networks over the next five to ten years.
Recent & Long-Term Stock Performance
Since NAREIT began tracking the sector in 2012, cell tower REITs have outperformed the REIT index in every year besides 2014. Cell towers continue to be one of the few remaining growth engines of the REIT sector and, considering the positive operating environment forecast for 2018-2020, don’t appear to be slowing down anytime soon.
The good times have continued for the cell tower REIT sector this year despite the merger uncertainties. The Hoya Capital Cell Tower REIT Index has gained more than 19% this year compared to a 14% gain in the broader REIT index. Receding interest rates and signs of moderating global growth have lifted REIT valuations across the sector following the worst year since the recession.
American Tower has led the way over the last two years, followed by SBA Communications. Investors remain somewhat skeptical on the economic returns from Crown Castle’s significant investment in fiber and small cells over the last several years, explaining some of the underperformance since 2016.
Valuation of Cell Tower REITs
Strong performance over the past four years has pushed cell tower REIT valuations towards the most expensive end of the real estate sector. Cell towers trade at a sizable Free Cash Flow premium (aka AFFO, FAD, CAD) to the REIT average, but after accounting for the sector-leading expected growth rates, cell tower REITs very quite attractively valued based on the FCF/G metric. As discussed above, cell tower REITs trade at some of the widest NAV premiums in the real estate sector, giving these companies the “cheap” equity capital to fuel further external growth.
Cell Tower REIT Dividend Yield
Cell tower REITs are among the lowest-yielding REIT sectors, paying out just 53% of their free cash flow and instead of plowing that capital back into the business to fuel external growth. The sector pays an average 2.2% dividend yield, among the lowest among REITs.
Within the sector, only Crown Castle acts like a typical REIT when it comes to distributions. CCI pays a healthy 3.7% dividend yield, while AMT pays 1.9%, and SBAC does not yet pay a dividend.
Cell Tower REITs & Interest Rates
Cell tower REITs skew towards the “growth” side of the real estate sector, reacting more to economic growth expectations than to changes in interest rates. Among US REIT sectors, cell towers are the third least interest rate sensitive sector and could provide balance to an otherwise rate-sensitive REIT portfolio.
Within the sector, AMT and SBAC are classified as Growth REITs. CCI, which pays a 4% dividend, is a Hybrid REIT and has characteristics that are more aligned with the REIT averages.
With 5G on the horizon, Cell Tower REITs have outperformed the broader real estate sector in each of the past four years. 5G technology will fundamentally disrupt the telecommunications industry. We believe that the true “killer app” for 5G will be fixed wireless broadband internet, as dense small cell networks will allow carriers to deliver fiber-like speeds without the wires.
The technological limitations of 5G – notably the small coverage area – mean that macro towers will continue to be the primary hub of cellular networks. Network densification drives cell tower revenues. The Sprint/T-Mobile merger saga continues. Just when a deal appeared imminent, a new curveball emerges. We think that Sprint’s troubles are overstated and that no-deal outcome would benefit tower REITs.
Cell tower REITs continue to benefit from a favorable competitive positioning within the telecommunication sector. Low supply and high demand have translated into substantial pricing power for cell tower operators. We analyzed the three potential merger outcomes and believe that a no-deal scenario would be the best-case scenario for these companies. This analysis, however, is contingent upon our view that wireless broadband does indeed become the “killer app” of 5G and that Sprint is a valuable partner or acquisition target from a third-party (cable or technology) company as a result.
The risk of a no-deal outcome is that the carrier industry devolves into an effective duopoly, which would translate into significant downside risk to the competitive positioning of the cell tower REIT sector. The success of the early 5G fixed wireless broadband tests in a handful of US cities will be closely monitored by all players in the industry and the ultimate fate of Sprint may hinge on its relative success. If wireless broadband is indeed the 5G “killer app” we think it could be, the future looks bright for cell tower REITs and carriers alike.
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Disclosure: I am/we are long AMT, VNQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: It is not possible to invest directly in an index. Index performance cited in this commentary does not reflect the performance of any fund or other account managed or serviced by Hoya Capital Real Estate. All commentary published by Hoya Capital Real Estate is available free of charge and is for informational purposes only and is not intended as investment advice. Data quoted represents past performance, which is no guarantee of future results. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy.
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