Must-Know Info for Investing in Commercial REITS, If You Dare

Real Estate Investment Trusts (REITS) have long been a favorite holding for high-dividend investors. The recent bankruptcy filing of General Growth Properties (GGP) puts the spotlight on this group, particularly the Commercial REITS.

Those following my series, The High Dividend Investor’s Collapsing Dollar Survival Guide, or my newsletter, will note I’ve NO U.S. commercial REITS on my list of recommendations. In the past, their holding of hard assets and often generous and stable dividends would have made them legitimate candidates. No longer.

My readers may note that I do have a few Canadian REITS in the portfolio. These include commercial REIT RIOCAN (RIOCF.PK), (TSX: CAR.UN), as well as

• Canadian Apartment REIT (CDYPF.PK), (TSX: CAR.UN)
• CML Healthcare Inc. Fund (CMHIF.PK), (TSX: CLC.UN)
• Northern Property REIT:(NPRUF.PK), (TSX: NPR.UN)

Why? The healthier Canadian banking system makes the lending situation there better, and this is key. Of course, the firms themselves have posted solid results, have performed well, and sport high, reliable yields. So far, so good.

What killed GGP was its inability to refinance debt coming due. Much of its operations were OK and it continued to meet current debt payments on most of its malls. For example, in Q4 of 2008, GGP posted a solid 92.5% occupancy, though cash flow suffered along with the rest of the consumer sector.

There’s plenty of potential for more trouble with the commercial REITs. Per Deutsche Bank, two thirds of about $154 billion of securitized commercial mortgages coming due between now and 2012 will not qualify for refinancing due to the 35% - 45% decline in property values since their 2007 peak. This estimate could get far uglier if even about 10% of mall properties need to be sold off. There are relatively few buyers for such big ticket properties. Thus commercial property values would drop further, thus lowering the value of the surviving commercial REITs and making financing harder still.

I won’t even get into what declining commercial property values will do to the asset values of the already battered banks that hold the mortgages, though suspension of mark-to-market accounting will help preserve appearances, at least for a while(?). So far the government has been very willing to join the banks in erecting a façade of health, so why not here too. What options do they have?

1. What Income Investors Need To Consider

First, not all REITs are created equal. The commercial sector is the most vulnerable, and the retail sector the most vulnerable of the commercial sector, though there are pockets of relative stability. Residential REITs, healthcare REITS, or even commercial office building REITs with heavy exposure to government or other very commercial stable tenants AND that have manageable debt loads will survive and ultimately prosper.

However, unless you’ve specific well researched evidence or advice suggesting otherwise, be very wary of commercial REITs, especially those with retail exposure. During the next 6-12 months, there are likely to be lots of distressed sales and the sector will be badly depressed, and that might be a time to find opportunities in which the reward justifies the risk. When that time comes, apply the following criteria when evaluating REITs.

2. Criteria for Evaluating REITs

In short, investors need to first consider if the companies have the means to manage their debt load without seeking out new financing sources. If they can do that for the next number of years to survive until things improve, then you can look at how well funds from operations exceeds current debt payments, then consider the safety of the dividend.

A. Specific Criteria Include:

• Relative Debt Load: Again, inability to refinance is what killed GGP. Like any business comprised of big capital assets, be they power plants, pipelines, or retail malls, these firms use lots of debt. Commercial property values are likely to weaken more, making refinancing even tougher. The overriding concern is to look at various measures of the firm’s ability to meet debt obligations without seeking out new financing.

Specifically, examine:

o Debt to equity ratios: These should be much better than 1:1, because in the event of bankruptcy, costs of the bankruptcy process could consume any surplus left after creditors

o Ability to meet long term obligations coming due in the next 5 years, during which time refinancing from conventional sources at affordable rates will be hard. Specifically, what provisions have they made to pay off this debt? Have funds been set aside? When do they have any large debt coming due? How much of unused credit lines, if any, are available.

o Ability to meet short term obligations: For example, calculate the quick ratio (liquid assets/short term obligations) to see how they can manage for the next fiscal year. You want to see something much better than 1:1. In addition to this ratio, look at the actual amounts of liquid assets compared to debt payments and other obligations over the next year.

• Income from Operations: Once you believe the REIT can survive ongoing debt and operating expenses, then look at the day to day health of the business. If the operations aren’t profitable, debt will ultimately be a problem, even if they have the cash for now.
• Get some measure of dividend payout ratio: Once you’re satisfied they’ll survive, how safe is your dividend? Income is usually the reason for investing in REITs in the first place. In general terms, payout ratio is the actual total dividend payments divided by the total distributable cash available after covering current operations and debt payments. For very steady revenue businesses like power suppliers, we like to see payout ratios under 90%. For businesses with volatile revenues like energy producers, we want no more than 70%. For truly troubled sectors like retail REITS, the lower the better, like 60% and lower, to provide a cushion of cash for maintaining the dividend until things improve.

B. Where To Find This Data?

For those not inclined to analyze financial statements, check the Management Discussion and Analysis (aka: MD &A) included with most quarterly financial statements, which you can access on the company’s website. If still unsure, email your questions to investor relations via the email address on that website.

3. CONCLUSION

As long as people need places to live, work, and shop, the REITs will have demand. However their need for debt combined with a severe recession and concomitant decline in consumer spending makes investing commercial REITs treacherous at this time, so use the above and other criteria to carefully evaluate investments in REITs, especially commercial REITs, and especially retail REITs.

DISCLOSURE: The author may have positions long or short the above mentioned stocks.

Comments

[Dividend Gr...:]

Cliff,

That's a great article. I enjoy your insight into income producing stocks. As an owner of several REITs myself I am also monitoring the cash flow situation for my investments in order to gauge how sustainable the current dividend payments are.

Apr 17 05:16 PM

[Alan Young:]

At last! A well-reasoned and fully informative guide to REIT investing. I still wouldn't touch 'em with a 10-foot hedge, but I'm glad someone is talking sense here.

Apr 17 06:03 PM

[{5U}:]

The rallies in the REITS is all part of The Conspiracy of Hope.

The latest spark was the Goldman upgrade of SPG. The pundits have piled in. Now there is talk of REITs buying the secured debt of more battered REITS.

Don't these REITS have their own refinancing issues. But wait, SPG is up 60% from where it sold stock. They should just sell even more stock! Sell stock until the market says no!

Apr 17 09:55 PM

[roswellric:]

I think the author is confused about payout ratios. Reits are requied by law to distribute 90% of their profits with certain exceptions and deferrals.

Apr 18 06:53 AM

[nym:]

On Thursday I sold my holding of Vanguard's REIT index at a loss of >50%. It would have been worse without the recent run-up, but for me it was a stop-loss action.

Apr 18 10:02 AM

[Old Trader:]

roswell,

Perhaps he meant to refer to FFO (funds from operations), the preferred metric for evaluating REITs, instead of EPS. One of the "certain exceptions" you mention is the possibilty of issuing dividends by means of paying out in shares. Granted, this hurts current retirees relying on cash to fund their retirement, but it DOES give the firms some wiggle room in managing their cashflow through a tight credit market, and several REITs have done so, recently.


On Apr 18 06:53 AM roswellric wrote:

> I think the author is confused about payout ratios. Reits are requied
> by law to distribute 90% of their profits with certain exceptions
> and deferrals.

Apr 18 11:19 AM

[RiskReturnO...:]

An alternative way to produce income is to set a target yield band on the REITs you hold, for example 8%-10%. When the yield drops below the lower end (price goes up), you can either reduce 30% of core position or sell some at the money calls (to extract more income); when the yield increases above the upper end (prices drop), you can either cover your calls, or add more to the core position. This strategy has worked well; the key to the determine the right target yield band that you are comfortable.

Apr 18 12:27 PM

[Econ 101:]

This analysis would be fine except that it is rearranging deck chairs on the Titanic. Over the next few years oil and gas prices will increase and people will have to shop on a smaller scale. Malls will be ghost towns, America will change from a consumer society to a society struggling to survive. The rest of the world will be worse, but America will never be the same. Over built commercial real estate has yet to plummet in value, GGP is just the first step.

Apr 18 02:31 PM

[davidbdc:]

Respectfully disagree that retail REIT's are the worst. Office buildings are being hammered in terms of rents. Regional malls are having a tough time but rents are holding up better.

Yes, refinancing is going to be challenging for some, but not for all. Why wouldn't a bank roll over a mortgage if the underlying cash flow comfortably pays the interest on the mortgage? Do you think Banks want to start owning portfolio's of shopping malls?

Strip malls, suburban office space, and industrials with large development pipelines are going to suffer. Regional malls that weren't purchased in the past 5 years will do just fine. GGP bought malls at stupid prices with all debt......don't extrapolate their actions to the entire sector.

No risk, no reward. Fear of the REIT sector is extremely high - and those that choose wisely will live well for many years.

Apr 18 02:44 PM

[woodsey:]

Can you imagine Bear forcing Thornburg to the wall? Good bye REITS.

Apr 18 05:33 PM

[realold:]

I tend to agree with your points but sure could use a theory on why retail reits such as Realty Income (O) are doing so well??

Apr 18 06:53 PM

[whisperonth...:]

I'd look for the US version to avoid paying the foreign taxes. I'm already taxed beyond my comprehension, and I fully expect to see even higher taxes here over the next 4 years. I don't want to add additional taxes voluntarily even if they are accounted for on Apr. 15th. If I'm going for dividends, I want them all.

Apr 18 10:47 PM

[Cliff Wachtel:]

Right on. Again, it's a risky sector, but those who bought judiciously and resisted the recent high valuations will be in a postion to buy depressed assets at bargain prices, which is when one is supposed to buy them. People still need to shop, and well located malls offer centralized one-stop locations that will allow consumers to travel less. Malls also are likely to have some kind of mass transit servicing nearby. Thanks for your input, Cliff


On Apr 18 02:44 PM davidbdc wrote:

> Respectfully disagree that retail REIT's are the worst. Office buildings
> are being hammered in terms of rents. Regional malls are having a
> tough time but rents are holding up better.
>
> Yes, refinancing is going to be challenging for some, but not for
> all. Why wouldn't a bank roll over a mortgage if the underlying cash
> flow comfortably pays the interest on the mortgage? Do you think
> Banks want to start owning portfolio's of shopping malls?
>
> Strip malls, suburban office space, and industrials with large development
> pipelines are going to suffer. Regional malls that weren't purchased
> in the past 5 years will do just fine. GGP bought malls at stupid
> prices with all debt......don't extrapolate their actions to the
> entire sector.
>
> No risk, no reward. Fear of the REIT sector is extremely high - and
> those that choose wisely will live well for many years.

Apr 19 10:21 AM

[Cliff Wachtel:]

I'd need to look at it, but as I said, there are pockets of stability. The operating environment for REITs is tougher, but hardly impossible for those well run firms that either don't need new financing or are healthy enough to justify getting it at affordable rates. I don't know if RI is one of those, will need to check. Thanks for your comments, Cliff


On Apr 18 06:53 PM realold wrote:

> I tend to agree with your points but sure could use a theory on why
> retail reits such as Realty Income (seekingalpha.com/symbol/o)
> are doing so well??

Apr 19 10:25 AM

[MichaelD:]

How would you analyze the prospects of a well-diversified ETF like VNQ over a long time-horizon, say 7 years? Say one assumes that the REIT index returns to its long-term average yield over those seven years. Is this reasonable? Or does one need to factor in above-normal bankruptcies? If so, what would be a reasonable assumption? I am investing through a handful or ETFs rather than individual equities. Thanks.

Apr 28 04:48 PM

[Andy1234:]

You could also take a step back.....and look at the economies of the countries you are investing in...and the shape they might be in if given inputs are tested.

For instance....someone said if oil and gas go up in price. I fully suspect this will happen sometime in the future whenever we have a dollar crisis, peak oil crisis, both, or economies recover.....but I think its a pretty safe bet that prices will increase from the current price.

Countries that export energy should benefit from increased pricing in both currency exchange pricing or real price increases in energy prices (gains against other commodities or gold). One could assume that countries like Canada and Brazil would benfit from this...and their economies and currency strong. One could play REITS this way.....as I do. I think america is going to have a tough time all around.

May 15 01:27 PM