The REIT Way To Separate The Wheat From The Chaff

by: Brad Thomas

It's funny to see how so many financial planners (and journalists) tell you what to buy, but they rarely tell you what not to. In a previous article I addressed that issue described as "fluffy" investing when I explained that my writing style is not based on always being right, but more so on learning from my mistakes and correcting them. As I explained:

One of my frequent fans (just kidding of course) on Seeking Alpha constantly reminds me that I need to include the risks in research. In other words, he likes to use the word "fluffy" as he describes the fact that some of my articles (in his words) are deemed "brochure-like".

As mentioned, I can eat "crow" and in fact, I can admit being wrong just as easy I can admit being right. The simple truth is that I have learned to accept the fact that I'm not always right; however, I work extremely hard not to be wrong. When you boil it all down, it's the experiences in life that make us all better investors. I don't mind "eating crow" every day as long as I can learn from my mistakes.

It's true. I think all of you reading this article will admit that the failures in life have all led us to successes. Having five kids to raise I often remind myself that we must all pick ourselves up off the ground, dust ourselves off, and keep plowing ahead. As I wrote previously, "it's the experiences in life that allow us to become disciplined investors and that skill-set is how the legendary investor Benjamin Graham became hugely successful."

But we know Graham had some tough times so what was it that made him so successful? There had to be something that set him apart and ultimately steered him to be one of the most widely acclaimed value investors in history. Simply put, why did Graham stress the danger of risking capital over the potential for rewards?

It All Boils Down to Separating the Wheat from the Chaff

From our failures we have all become more conservative investors and I for one have become a discipline of the "margin of safety" principle. By utilizing the wide applicability of the powerful (margin of safety) concept I can proceed with certainty that, regardless of day-to-day price fluctuations, that my principal is secure. Graham summed up the tenet of his investment philosophy as follows:

An investment operation is one which, upon thorough analysis, promises safety of principal and satisfactory return. Operations not meeting these requirements are speculative.

We have all heard the saying: "separate the wheat from the chaff". In Biblical terms (Luke 3:17), that means one should bifurcate the good and valuable (the wheat) from what is worthless (the chaff). That metaphor is derived from the fact that you have to separate the chaff (the inedible hull of the wheat) from the actual wheat that you can eat when you harvest it. In Psalm 1 the author (King David) wrote:

Not so the wicked! They are like chaff that the wind blows away.

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The REIT Way to Separate the Wheat from the Chaff

Today we saw another day of sell-off in REIT-dom. Most of my REITs declined; however, I'm getting more excited to see the shares going on sale. When I got home from work today I glanced over some of my prospective REIT investments and I'm starting to see my entry targets inching closer and closer.

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In the book, Margin of Safety, by Seth A. Klarman, the author wrote:

Investment research is the process of reducing large piles of information to manageable ones, distilling the investment wheat from the chaff. There is, needless to say, a lot of chaff and very little wheat. The research process itself, like the factory of a manufacturing company, produces no profits. The profits materialize later, often much later, when the undervaluation identified during the research process is first translated into portfolio decisions and then eventually recognized by the market. In fact, often there is no immediate buying opportunity; today's research preparation for tomorrow's opportunities. In any event, just as superior sales force cannot succeed if the factory does not produce quality goods, an investment program will not long succeed if high-quality research is not performed on a continuing basis.

So should REIT investors run for cover? After all, most have been hit hard with the continued declines.

First off, remember that REIT fundamentals are still solid and the demand for commercial real estate remains strong. We are in a current situation (cycle) where demand is greater than supply and most landlords are in a position to raise rents. Regardless of rising interest rates, that won't change. Regardless of whatever is in vogue in terms of investor demand over the next 12 months, REIT fundamentals are strong.

Secondly, and for dividend investors (and especially REIT investors), it's time to separate the "wheat from the chaff". As prices have declined, REIT investors focused on durable dividends have lately reaped a bountiful harvest - make sure it's wheat, not chaff.

Warning: Investors who are allured to the highest-yielding REITs they can find may find themselves with chaff. Rising interest rates may hurt some types of dividend-paying stocks far more than others - and some of the mortgage REITs are getting hit the hardest (and the bottom is not in sight).

The biggest challenge today is protecting those dividend holdings while minimizing risk (volatility) of the ups and downs of the value of your investments. Accordingly, REIT dividends provide a cushion to potentially weather the storm of (potential) losses incurred during a severe market sell-off. Because dividends play a much smaller role in the total returns of other equities, investors with REIT exposure have more cushion to weather the loss of value, while at the same time building a sound portfolio of income repeatability.

Steadily growing REIT dividends can help maintain purchasing power in retirement. In some cases, a high paying dividend yield may indicate that the market has knocked down the stock price in anticipation of a potential dividend cut. The best strategy for REIT investors is to examine the sustainability of the dividend and to stay away from the speculative (the chaff) securities.

In summary, the REIT way to separate the "wheat from the chaff" is to run from the speculators. Another way to frame the message is to define your number one goal of investing by "protecting your principal AT ALL COSTS. In the book, Margin of Safety, Seth A. Klarman offers his sage advice:

Mark Twain said that there are two times in a man's like when he should not speculate; when he can't afford it and when he can. Because this is so, understanding the difference between investment and speculation is the first step in achieving investment success.

But wait. How can we measure investment success and what return is sufficient? Ben Graham explained:

A satisfactory return…is a subjective term; it covers any rate or amount of return, however low, which the investor is willing to accept, provided he acts with reasonable intelligence.

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Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended.


Source: SNL Financial

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Disclosure: I am long O, ARCP, HTA, HCP, VTR, DLR, CSG. 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.