Why Investors Should be Fearful of REITs, Despite Their Relatively High Dividend Yields

by: The Lonely Value Investor

I've always disliked the REIT (real estate investment trust) structure in the belief that it forces a company to operate in a highly unnatural way. Mandatory cash distributions forces most REITs to constantly access capital markets. They seem to be in a constant search for cash. In any case, REITs frequently end up over-leveraged, at least to my liking.

The REIT structure is an arbitrary construction of the tax code that provides favorable dividend treatment in exchange for meeting certain obligations. Chief among these is that a company must distribute at least 90% of taxable income to shareholders.

These constraints cause me to be a REIT skeptic at best. So weigh the following thoughts accordingly.

Nonetheless, it's amazing how quickly a hefty dividend warms my cold, dead capitalist heart. The trouble is, I am (just) old enough to remember when yields of 12 to 15 percent were easy to find in the REIT universe. Such yields are NOT ancient history. Think Internet Bubble days, without "Flip That House" shows on HGTV. Real estate wasn't virtual and, therefore, nobody cared. Not coincidentally, it was a great time to buy REITs.

At the time, high yields were said to compensate investors for the considerable risks they bore. Sounded reasonable to me. With interest rates in constant free fall for the last 10 years, REIT yields have fallen as well. Today's buyers argue that REIT yields are still relatively attractive. The key word here is "relatively". It can be a thoroughly dangerous word.

Call me crazy, but at some point absolute levels matter.

REITs have been pursued by yield-seeking investors searching for alternatives in a near zero interest rate world. At some point, any positive yield starts to look good. Relatively speaking. In the case of REITs, this buying has now driven yields to ridiculous levels. Absolutely speaking.

Frankly, REIT yields may look good compared to [blank], but it is an apples to oranges comparison in many cases. REITs are essentially a pass-through vehicle. Is a 3% yield on a REIT the same as a 3% yield on Johnson & Johnson (NYSE:JNJ) or Kimberly-Clark (NYSE:KMB)? Since by law the REIT yield represents at least 90% of taxable income, the answer is "no".

In any case, current REIT yields don't look sufficient to compensate investors for the risks being assumed. In short there is no margin of safety.

Given the nature of real estate, is a 6 percent yield enough? How about 3%?

Excluding the mortgage REITs, like Annaly (NYSE:NLY), double digit yields within the REIT universe are nearly impossible to find. Even 8% is rare! Conversely, yields of 2 to 4 percent are abundant. Apparently investors must believe that minuscule retained earnings and appreciation of the underlying assets will offset these pathetic current yields?

It's too great a leap for this investor, but it is clearly a minority view.

Just look at mall operator Simon Property Group (NYSE:SPG). Its 2.5% dividend yield would imply an earnings yield, cap rate, or whatever for the whole company of less than 3%. Round up if you want. Either way, precious little margin of safety exists. At best, it seems like a very full price to pay for a collection of mall properties. Or am I missing something? Is retail booming? Mall retailers in particular? You'd think so given SPG's valuation. Sorry, but I can't suspend my disbelief. Our local mall (a Simon property) is a ghost town. Maybe all the rest are thriving. They better be.

Look through the whole collection of retail REITs from factory outlets to strip malls and it's the same story. Whether it's Taubman (NYSE:TCO), Tanger Factory Outlet Centers (NYSE:SKT), Realty Income (NYSE:O), or even Saul Centers (NYSE:BFS), you're lucky to break 4 percent for current yield or even total earnings yield. Been shopping lately? Was there a line?

In a time of belt-tightening and sacrifice, one could imagine that self storage would be a tough sell. Not so based on the price of REITs like Public Storage (NYSE:PSA) or U-Stor-It (YSI). Crazy multiples and tiny yields are the order of the day.

Did we have a real estate correction in this country?

Not if the apartment REITs are any indication. AvalonBay (NYSE:AVB), Camden Property Trust (NYSE:CPT), and Post Properties (NYSE:PPS) - to name a few - are all trading within shouting distance of their 52-week highs and yield around 3 percent. Hold me back!

I know... everyone who's lost their house is now paying full bore to live in a luxury apartment owned by one of these guys, right?! Sure. And 10% unemployment isn't hurting them either? Not based on these numbers. Was my complex the only one with empty apartments and residents behind on their rent? Apparently.

From office REITs - like Boston Properties (NYSE:BXP) to hotel REITs - like LaSalle Hotel Properties (NYSE:LHO) and Host Hotels (NYSE:HST), everything must be booming. The valuations say so. But where is the downside protection? Have you spoken to a commercial realtor or a hotel operator lately? Investors in these companies clearly haven't! Such disconnects scare me.

The lumber REITs like Plum Creek (NYSE:PCL) and Rayonier (NYSE:RYN) and their 4+ percent yields look positively cheap by comparison. Lumber is in bull market mode. Did you know that? Even so, 4 percent? I grew up on a farm. Growing anything on the farm or in the forest has risks. And these numbers just don't cut it.

Even Vornado (NYSE:VNO), the king of diversified REITs has a pathetic 2.9% dividend yield and is priced for perfection. So count me among the few who are bearish on REITs in general.

Do we really need a reminder that real estate isn't riskless, that the associated cash flows are not certain? Who's buying these things? And at these prices?

It's not surprising that the Bloomberg REIT index topped out in early 2007 at around 300. If memory serves, it was right about the time Blackstone (NYSE:BX) bought Equity Office (EOP) from Sam Zell. 20 guesses who made out on that deal?

Blackstone's purchase valued Equity Office at a low single digit cap rate. How did their math work? After all, Blackstone used mountains of borrowed money. No doubt the model hinged on future growth, ever rising real estate prices, and a belief in the Greater Fool Theory. It's a formula that worked great in residential real estate! And Blackstone found a few.

For Sam Zell, Blackstone was the only "fool" he needed. Two years after the Equity Office deal closed, the aforementioned REIT index was 80 percent lower. The concept of risk was reborn and Sam Zell looked positively prescient. By March 2009, the index bottomed around 70. And because the world didn't end as expected, it began to rebound.

Today, the Bloomberg REIT index hovers around 170. Compared to 300, this is relatively (that word again) cheap. Take comfort in this if you wish, but 2007 represented a price bubble on top of a credit bubble... a double bubble.

With many REITs currently trading near Equity Office-like valuations, investors should be fearful of this sector.

Buying relatively cheap REITs could make you absolutely poor.