Why I Don't Currently Own Shares In REITs

by: Brad Thomas

My last Seeking Alpha article, Balancing Risk: REITs That Outperform in Good Times and Bad, received around 8,500 page views and 83 comments. The first comment of this editor's pick was from a reader asking, "Why don't you invest in what you write in favor of?"

Most readers responded in my defense with many voicing the common theme that it makes no difference whether I own REIT shares or not. One actively engaged blogger provided an excellent quote from John Maynard Keynes:

When the facts change, I change my mind…what do you do?

Today marks my 99th article, and, in case you haven't read my previous ones, I focus on the equity REIT sector where I research many of the "best in class" REITs. As part of my other professional activities, I stay actively engaged in most all commercial real estate sectors. I'm a director and investment banker at Bull Realty, and I execute capital markets transactions with a variety of real estate landlords, including REITs, private equity funds, investors, developers, brokers, and bankers. In addition to Seeking Alpha, I am a contributing writer for TheStreet and Forbes.

Rule #1 - Law of Leverage

Earlier in my professional life, I developed shopping centers and single tenant properties. For example, I built and leased around 40 stores to Advance Auto Parts (NYSE:AAP), and numerous facilities for O'Reilly Auto Parts (NASDAQ:ORLY) and Dollar Tree (NASDAQ:DLTR). I was a developer and landlord to many other national retailers including PetSmart (NASDAQ:PETM), OfficeMax (NYSE:OMX), Cato (NYSE:CATO), Red Lobster (NYSE:DRI), McDonald's (NYSE:MCD), and CVS (NYSE:CVS).

In 2002, towards the peak of my development career, I was in a partnership that leased larger boxes to chains such as Goodyear Tire (NYSE:GT), Wal-Mart (NYSE:WMT), Bi-Lo, and Goody's (now bankrupt). My business partner and I had a sound tenant mix as the portfolio was diversified with a variety of national and regional chains. Our portfolio was around 95 percent occupied and we rarely had issues accessing capital for new development or acquisitions.

In fact, we occasionally tapped the mortgage REIT sector to facilitate maximum leverage. Although we did not borrow from Northstar Realty Finance (NYSE:NRF), CreXus Investment (NYSE:CXS), or Colony Financial (NYSE:CLNY), we frequently borrowed expensive debt of around 15 to 20 percent interest from similar private and public REITs to maximize the concept of OPM (other people's money). Like most mortgage REITs, it is common to achieve wide spreads and pay dividends; however, the risk of leverage is considerable and when interest rates move, mortgage REITs become like salt on a slug and dividends dry up faster than the slugs do.

Rule #2 - Law of Transparency

My development partner and I had a large real estate portfolio, and I was a 49-percent partner in the business. The 51-percent partner was the manager and, because he was the majority owner, he made most of the financial decisions related to the property portfolio. Because our business was private it was difficult for me to obtain current financial statements, cash flow reports, tenant sales reports, and relevant financial information. In most cases, I had to request a meeting with my partner in order to obtain these items, and valuations on our properties were almost non-existent.

Like most partnerships, things go great when times are good but they can sour fast when things go bad. As an old friend once told me:

When poverty goes thru the front door, love goes out the window

Rule #3 - Law of Liquidity

When leveraged partnerships sour (See Rule #1 and #2 above), Rule #3, the Law of Liquidity, is like ice cubes and Eskimos. In other words, selling leveraged real estate in a private ownership structure is very difficult, if not impossible. Unlike a public REIT structure, there is no immediate liquidity option and an investor in private real estate is at the mercy of many.

Much like the non-traded REITs, these ownership structures have an unknown lifecycle and the trade-off between liquidity and volatility is a commonly argued theme for investors and financial planners. In fact, the liquidity argument is of considerable importance as there is considerable risk to owning real estate that is not owned in a liquid form.

Rule #4 - Law of Diversification

The final law (diversification) is a very common theme in my writing. Howard Marks outlines his company's motto in his book "The Most Important Thing":

"While aggressive investing can produce exciting results when it goes right - especially in good times - it's unlikely to generate gains as reliably as defensive investing. This, a low incidence and severity of loss is part of most outstanding investment records. Oaktree's motto: "if we avoid the losers, the winners will take care of themselves," has served well over the years. A diversified portfolio of investments, each of which is unlikely to produce significant loss, is a good start toward investment success."

I owned considerable real estate in one partnership. I was not diversified, and when things went bad, I suffered considerable losses because I was "all in." It took just one torpedo to sink the ship. As Sir John Templeton said,

The only investors who shouldn't diversify are those who are right 100% of the time.

Why I Don't Currently Own Shares in REITs

My personal and financial mantra is "huge failure makes huge success." The failures in my investment career were due to a combination of high leverage, low transparency, little liquidity, and no diversification. As I move forward - bruised but much wiser -- I am building a new investing strategy with the highest respect for all three principles. Priority one is to build liquidity ((NASDAQ:CASH)).

Once I build significant cash balances I will actively diversify into broad equity investments.

As you might surmise from reading my articles, I will overweight (20 percent in REITs) with high-quality blue chip REITs like Realty Income (NYSE:O), National Retail Properties (NYSE:NNN), Kimco Realty (NYSE:KIM), Federal Realty (NYSE:FRT), Tanger Outlets (NYSE:SKT), Taubman (NYSE:TCO), Simon Properties (NYSE:SPG), Prologis (NYSE:PLD) Avalon Bay (NYSE:AVB), and Weingarten (NYSE:WRI).

I will likely underweight with smaller growth stocks like Retail Opportunity Investment Trust (NASDAQ:ROIC), Excel Trust (NYSE:EXL), Extra Space (NYSE:EXR), Monmouth (NYSE:MNR), STAG Industrial (NYSE:STAG), EastGroup Properties (NYSE:EGP), and UHM (NYSEMKT:UMH).

I'm always researching sector rotation REITs and I have an interest in campus housing REITs like American Campus Communities (NYSE:ACC), specialty REITs like Digital Realty (NYSE:DLR) and Entertainment Property Trust (NYSE:EPR), and health care REITs like Omega Health (NYSE:OHI) and Health Care Realty Trust (NYSE:HR). I also like some of the new kids on the block like American Realty Capital Trust (NASDAQ:ARCT), and I'm keeping an eye on W.P. Carey (NYSE:WPC), which should be converted to a REIT in a few months.

For reasons noted above (liquidity and transparency), I'm not a huge fan of the non-traded REITs; however, I stay in front of the crowded sector because many of the non-traded REITs will one day become listed REITs. I actively research some of the well-balanced sponsors like Cole, CNL, and American Realty Capital. In addition, there are some interesting incubators like Strategic Storage Trust, TNP Strategic Retail Trust (Disclaimer: I used to work there), Dividend Capital, CB Richard Ellis Realty Trust and Phillips Edison (Disclaimer: I used to work there).

In summary, I am actively engaged in commercial real estate and I have a keen interest in researching and writing on REITs that provide safe-margin fundamentals and consistency distinguished by repeatable dividends. I think like a retail investor and not an institutional investor; consequently, my focus is on the principles of long-term investing with the primary goal of capital preservation. I have become an engaged student of Benjamin Graham and, like Graham, I have witnessed both the thrill of victory and the agony of defeat - and I like the former much better than the later.

Disclaimer: I own none of the REITs listed in this article (and I have no conflicts that prevent me from writing).

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