Legendary economist and famed investor Ben Graham once said,
A long-term investor is the only type of investor there is. Someone who can't hold on to stocks for more than a few months at a time is doomed to end up not as a victor but as a victim.
So how does an intelligent REIT investor determine how to invest for the "long term"? Maybe that answer lies in this question from one of Graham's exemplary students, Warren Buffett:
Do I buy stocks on the assumption that it'd be fine if the market closed tomorrow and didn't reopen for five years?
Maybe then, if you're prepared to buy and hold for five years, nothing but the best-positioned companies will do. Or maybe, the words "buy and hold" have gone the way of the dinosaur- especially, given the fear of the great recession. Maybe REIT investors are uncertain that property values will not return and those dividends will never become the durable darlings of the past.
Or maybe there are some REITs that are worth owning "if the market closed tomorrow" and maybe even then, these select few REITs could be described in the words of Oracle from Omaha:
Our favorite holding period is forever.
REITs to Hold Forever
Last week, my wife and I celebrated our twenty-year wedding anniversary. In hindsight, I cannot believe how fast the years have passed. I can still remember the vows:
In sickness and in health, in poverty or in wealth, 'til death do us part.
Wow! A long-term perspective changes everything. And so should investing. In other words, it is extremely important to consider the long-term implications of REIT investing and position your portfolio on the premise that "if the market did close for years", the companies would continue paying solid and growing dividends - in good times and bad.
So how does an investor sort through the 129 equity REITs with a combined market capitalization of $514 billion and identify the "crème de la crème" or what Matt Werner, CFA at Chilton Capital Management explains as the "REIT Elite" (in Chilton Capital's August 2012 newsletter):
Given the flight to safety that we have seen, this month we are going to discuss a group of REITs that we have deemed the 'REIT Elite'. These are the blue chip, core quality holdings that an investor should buy for his or her grandparents, parents, and children. They are the 'sleep at night', confidence-inspiring companies with management teams and operational expertise that REIT investors can rely on for above average earnings growth over long time periods, despite changing economic conditions. Due to fluctuations in valuation metrics, we may not hold them in our composite at all times, but they certainly would be in the portfolio if we had to pick stocks to hold for the next decade.
Dating is to marriage, as due diligence is to investing. In other words, investors should consider the long-term nature of the commitment and specifically pay special attention to the most important metrics surrounding the capital structure, predictability of the dividend, management team, and operational excellence.
These "REIT Elite" make a fantastic core for any portfolio, and they are divided among categories, providing investors with diversification by tenant, sector and geography. But the common thread that runs throughout: These REITs, anchored by dividend excellence, have solid competitive advantages that provide enduring and sustainable income that are difficult to replicate. To add, these REITs provide repeatable sources of income, in constant demand, regardless of the economic climate, and their sources of revenue is resistant (though not immune) to recession and technology.
In what I consider to be one of the best Seeking Alpha articles of all-time (Dividends Provide A Return Bonus), Chuck Carnevale wrote:
Now, here is the primary point behind this article. If you examine two companies with equivalent rates of earnings growth, where one pays a dividend and the other does not, the dividend payer will provide their shareholders a higher total return. In other words, we're suggesting that both stocks will provide equivalent capital appreciation when measured over a time period when the market is behaving rationally. We would define this as a time period when both stocks were being priced at fair value in the beginning and in the end. Consequently, the stock that pays a dividend to its shareholders is providing them a return bonus or kicker.
Later, I went on to reference Mr. Carnevale's work in an article I wrote for Forbes.com:
The concept of REIT investing is rooted in the same "cake and icing" blueprint that Mr. Carnevale wrote; however, the two elements (dividends and capital growth) are reversed for REITs making dividends the "cake" and capital appreciation the "icing". Furthermore, REITs help to balance the conventional common stock portfolio by reducing volatility and by providing a natural hedge against inflation.
REIT dividend yields have historically been a good deal higher than the average yield of the S&P 500 Index. Conversely, dividends make a big difference for long-term retirement savings and they can be reinvested to generate future returns, while in later years they can provide a steady income stream to help meet expenses in retirement.
So, while the average dividend yield of the REIT Elite may be well below the NAREIT average of 3.35 percent, a skeptic may rather invest in a REIT with a higher dividend yield. However, the dividend yield has two components: security of the current dividend and expected dividend growth.
During the credit crisis of 2008-2009, the capital markets closed to most US companies, including REITs. Without the ability to access capital amidst declining rents, many REITs had to cut their dividends to enhance financial flexibility. Remarkably, 9 of the 10 "elite" members did not cut their dividends.
In 2009, Simon Property Group (SPG) cut its cash dividend, but more than made up for it by paying the balance of it in stock. By the end of the year, the total value of the stock and cash distributed to shareholders was $4.23, which is still the highest dividend distribution on an annual basis since the company's IPO. On July 24th, 2012, Simon announced the new annualized cash dividend rate of $4.20, which is considerably higher than the cash dividend in 2008.
Despite the frequent dividend raises and lack of dividend cuts, the REIT "elite" had average payout ratios far below the average for the REIT sector of 74 percent. As Matthew Werner, CFA with Chilton Capital Management explains (in the company's August 2012 newsletter),
This gives investors confidence that the dividends will be increasing over the near and long term. Analogous to a bond that increases in price and decreases in yield after a credit upgrade from a ratings agency, the REIT Elite have experienced price appreciation resulting in a lower dividend yield.
Skillful Risk Control
Skillful risk control is the mark of a superior investor, and the "hold forever" REITs posses the best management teams in the country and therefore warrant premium valuation. Experience, service with other management team members, and razor sharp focus on being the best at a particular niche characterize the CEO, CFO, and COO of each member of the "best in class" brands.
Accordingly, intelligently bearing risk for profit is what separates the best from the rest, and the "hold forever" REITs have demonstrated exceptional risk-management talents that go far beyond the average executive-level employee. As explained by Matt Werner, CFA with Chilton Capital Management (in the company's August 2012 newsletter):
An outsider looking into the REIT landscape could easily make the assumption of thinking a REIT is merely a collection of buildings, instead of a company with employees and future value creation potential. We argue that a strong leadership team is as, if not more, important in the real estate business than in other sectors for several reasons. First, there is constant cash flow coming into the business, which requires prudent capital allocation decisions. Second, real estate is characterized by high leverage so a CFO must be disciplined to maintain relatively conservative targets. Third, the risk and return associated with development is alluring and should only be attempted if there is a favorable track record to assure shareholders there will be value added.
In addition to the superior capital allocation skills possessed by the best management teams, the most successful REITs are the best in their business at growing cash flow at the property level. This process begins with selecting the best cities and submarkets to own commercial real estate.
Experience has positioned the elite members to have 'local sharpshooters' who are able to drive higher rents and occupancy at their properties relative to the submarket averages. REITs that focus on having 'boots on the ground' are better able to anticipate move outs, backfill empty space, and maintain the right 'tenant mix' to drive higher rents and occupancy.
A Flight to Quality
'Flight to Quality' is a term used to describe the movement of money from higher risk assets to lower risk assets. For example, the flight to quality helps to explain why the 10-year US Treasury yields hit new all-time lows in July at rates below 1.4 percent on July 24-25. It's the reason that the German 10-year Bond yield traded at 1.3 percent the same day. For the same reason, the dividend-paying stocks with predictable earnings streams are receiving a disproportionate amount of investor flows. The US-centric, contractual rent revenue streams of REITs have become an attractive investment for those interested in income and growth.
Similarly, the "hold forever" REITs have experienced a flight to quality as investors have sought the safety of the class A buildings in class A locations. As explained (in the Chilton Capital 2012 newsletter) by Matt Werner, CFA:
The above average returns this year coupled with the expensive valuations indicate the perceived premium for the REIT Elite characteristics has increased. Though it has manifested differently in each stock, the A quality properties are experiencing higher growth than the lower quality buildings. For example, the luxury consumer has been buying above 2007 levels, bringing more sales to luxury mall REITs Simon Property Group and Taubman Centers (TCO).
Increasingly, defensive investors have gravitated to the "shares of important companies with a long record of profitable operations and in strong financial condition (Graham)" and the "life time" REITs could be defined by the "Intelligent Investor" as he wrote:
One of the most persuasive rests of high-quality is an uninterrupted record of dividend payments going back over many years. We think that a record of continuous dividend payments for the last 20 years or more is an important plus factor in the company's quality rating.
Go With Your Gut
Graham was not just one of the best investors of all time; he remains far and away the greatest thinker about investing who ever lived. Warren Buffett has said:
Ben had more influence on me than any person except my father… Graham was the smartest man I ever knew.
Throughout his writings, Graham is not concerned with how people ought to act; instead, he focuses on how they actually behave in the real world. All his recommendations are based not just on what people should do, but on what they can do. Graham knew that self-control and self-knowledge are the keys to successful investing. In his words,
The investor's chief problem -- and even his worst enemy -- is likely to be himself.
If you read nothing but Chapters 1, 8, and 20 of The Intelligent Investor, you can get off the self-destructive path that sends so many people astray in their financial lives.
Risk assessment is an essential element to making decisions and as I contemplated marriage almost twenty years ago, I recall my decision - much like investing - was based on the fear of the unknown. However, as I have learned, it is the emotional mindset of the decision that separates the winners from the rest of the pack: The Psychological Factor. As Ben Graham explained,
Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it - even though others may hesitate or differ. You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.
Ben was right. I picked a winner! Here are my REITs to Hold Forever, Most Likely (includes latest dividend yields):