Risky REIT Sectors To Watch Out For

| About: Vanguard REIT (VNQ)

Summary

Have you stepped up the risk scale in REITs?

Now would be a good time to examine those risks.

Here are a few REIT niches that you might want to worry about.

Real estate investment trusts, or REITs, are a wonderful investment option for income seekers, especially in a low-yield world that hasn't gone unnoticed, with investors pushing the asset class materially higher in recent years. With the broadly diversified Vanguard REIT Index ETF (NYSEARCA:VNQ) off some 10% from its recent highs for the second time this year, though, you might want to reexamine your REIT risks - just in case 10% is only the start of a bigger downturn. Here are a few niches to worry about.

Relying on the government
For years Washington REIT (NYSE:WRE) was a slow and steady grower focused exclusively on the Washington D.C. area. The logic being that the government being run from D.C. would always support the region's occupancy and rents. Only that didn't work out as planned, with Washington REIT ending up selling assets, revamping it business profile, and cutting its dividend after the U.S. government went on a cost-cutting binge. With the fractious nature of politics today, I'd be worried about any company that's focused on D.C.

Or on the exclusive service of government renters like Government Properties Income Trust (NYSE:GOV). The whole purpose of this particular REIT is to rent to the government. True, it's more diversified, with properties in some 30 states or so. However, it still has one main customer, Uncle Sam. If there's financial issues at the government level, perhaps because of unfunded pension liabilities or something minor like that, Government Properties Income Trust could find its niche isn't what it hoped it would be.

Farming the land
Another niche that's worth taking a second, risk focused, look at is farms. There's really only two public players in the space right now, Farmland Partners (NYSE:FPI), which just agreed to buy smaller rival American Farmland (NYSEMKT:AFCO), and Gladstone Land (NASDAQ:LAND). There's nothing inherently wrong with owning farms, but Farmland Partners and Gladstone Land are both young and currently in growth mode.

In other words, there's little history to back up their stories. Maybe this asset class will work out just fine over the long term, but maybe it won't. So far investors have been pretty tentative about putting their money to work here, noting that farmers are facing material headwinds today in the form of low commodity prices. At this point the only investors that should be putting their money in either of these REITs are ones that have a good handle on farmland.

Back to school
Another niche that should be watched carefully is college housing. The big names here are American Campus Communities Inc. (NYSE:ACC) and Education Realty Trust Inc. (NYSE:EDR). Another REIT, Campus Crest Communities, wound up selling itself to a private equity firm because things weren't going as well as planned.

On the one hand, owning dorms is kind of like running an apartment building. So you can say that these are simple investments. However, there's a lot more going on, including seasonal leases, school reputations, and potentially limited growth opportunities. And the big story relies on the continued belief that every high school student in the United States should end up in college. Those are a lot of question marks in my mind.

A big wager
Then there's gambling REITs like relatively new Gaming and Leisure Properties Inc (NASDAQ:GLPI) and even younger MGM Growth Properties LLC (NYSE:MGP). The first risk here is that a REIT owning casinos is an untested story. On the surface it sounds great, but we haven't really seen what happens in a downturn. Perhaps gamblers stop gambling and rent coverage gets a little tentative.

But there's a potentially bigger issue over the long term. Despite MGM Growth Properties including the word growth in its name, I'm not sure how much growth potential there really is in the space. Great properties are going to be concentrated in select areas and how many companies are going to willingly part with truly great assets? For example, MGM Growth Properties' parent held back its best properties when it spun the REIT off. That said, a great property could come up for sale if its owner is suffering through trying times, which means maybe the casino operator isn't such a great tenant to have. Once again, I don't think this story has proven itself yet.

Going to jail
Another big question mark for me is prison REITs like Corrections Corp. of America (NYSE:CXW) and GEO Group Inc. (NYSE:GEO). For starters the main customer is the government, which can cause all sorts of problems, as I noted above. For example, both of these REITs took a big tumble recently when the U.S. Justice Department announced it would no longer be using third parties to run its jails. Although neither of the REITs was really going to be impacted too much by the DOJ's move, at least not right away, it's pretty clear that investors in the space don't understand what they own by the reaction to the news.

So not only is there heavy customer concentration in the government, there's a misunderstanding about what these REITs really are in the market. That's a recipe for disaster. I'm also not sure just how much growth potential there is in running jails for profit. My two cents is the risks outweigh the benefits.

The middle
One last question mark to throw out is CorEnergy Infrastructure Trust (NYSE:CORR). This REIT owns midstream energy assets. That's not a big problem in and of itself, after all limited partnerships have owned such things for years. However, putting them in a REIT is something new. It changes the model from a fee for service to rent. In some ways this is better, but CorEnergy is the only REIT of its kind and, well, it's being put to the test today.

There's no way to candy coat what's going on - the company's two largest customers are working through bankruptcy. These two customers account for around 90% of CorEnergy's rental revenue. Although both remain current on their rent, if something should go awry CorEnergy's unique approach to the midstream space could turn out to be a failed model. It's just not worth the risk for most investors.

Think now before it's too late
I'm not suggesting that anyone should sell out of a REIT they understand and believe in. However, the REIT niches I've highlighted are a few that stand out to me as riskier than they might have appeared when investors were clamoring for REITs. If the recent 10% decline in the broader REIT space starts to snowball, each of the companies noted above could find they don't have the market support they used to. Which is why now is the time to think through your risks before you end up acting based solely on emotion.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.