The term moat is an engaging word that vividly conjures up images of castles and the protection they provide. But what is a moat? The answer isn't as easy as you may think. With real estate investment trusts coming down from emotionally-driven highs, now is the time to think about the issue.
What's A Moat?
I actually don't like the word moat, a term popularized by Warren Buffett. Although it does create a great visual for investors to understand, it doesn't place that image in a wider context. I prefer the term durable competitive advantage.
Moreover, I like to think about durable competitive advantages in terms of a SWOT analysis. With a SWOT analysis, you are looking at a company's Strengths, Weaknesses, Opportunities, and Threats. It provides a broader view of the picture. A moat would fall into the Strengths category, but it would be a strength that is enduring and distinguishes a company from its peers.
Whatever words you choose, that's really the crux of the issue. You want to find a company that is different in a good way and that can sustain that difference over some period of time.
Which brings me to real estate investment trusts, or REITs. Do REITs really have durable competitive advantages and what do they look like?
Location, Location, Location
At its core, property is about location, location, location. So this is probably the first place to look for a competitive advantage. As an example, AvalonBay Communities, Inc. (NYSE:AVB) tends to own apartment homes in desirable high barrier to entry markets. That's good, but it isn't unique within the apartment sector - those are the markets that every competitor wants to own in. So, in and of itself, this isn't a moat.
However, add in two additional facts and AvalonBay suddenly has a moat. First, it is an expert at building properties from the ground up. Second, it is an active recycler of capital. So, AVB is focused on great markets, but its real expertise is finding places to build and seeing that process through to completion. But the process doesn't end there, AVB is always on the lookout for new opportunities and willing to offload older properties to help fund its newer ones.
Any one of these things alone isn't enough. For example, Washington Real Estate Investment (NYSE:WRE) is a diversified REIT operating exclusively in what had historically been a great market, Washington, DC. That was a great and distinguishing factor for a long time. But that moat went away when the Federal Government started to make cutbacks a few years ago. And it got even worse when WRE decided it couldn't grow large enough in some sectors to make it worth the effort. That led to a restructuring and a dividend cut. In other words, moats can fall away over time.
It's So Big
Size matters, sometimes. For example, Realty Income (NYSE:O) is a giant triple net lease REIT. That gives it access to capital that smaller players don't have. It also means that notable deals are likely to flow through its doors simply because everyone in the industry knows O is looking for acquisitions. Although size doesn't confer economies of scale so much in the triple net lease space, since the tenants are responsible for most operating costs, in some REIT sectors size infers even more advantages.
But size alone isn't enough. VEREIT (NYSE:VER), formerly known as American Realty Capital Properties, is a good example. This REIT got big fast. And for no better reason than to get big. There wasn't much thought put into the acquisitions and the impact on the portfolio - or the impact on running the company. When accounting errors popped up, it became very clear that size wasn't an advantage for VEREIT. In fact, with new leaders in place, the company is looking to slim down by jettisoning less desirable properties picked up during the growth binge.
And then there's the not-so-small impact that size has on growth. The bigger a company gets, the harder it is to move the needle on the top and bottom lines. While Realty Income may see a lot of deals, it needs a lot of deals if it wants to keep growing. Smaller players like National Retail Properties (NYSE:NNN), with a portfolio around half the size, will find growing a lot easier.
Diversification is a tough one because the ultimate goal is to reduce volatility. That's not inherently a competitive advantage. But a REIT like W.P. Carey (NYSE:WPC) shows that it can be turned into an advantage if done well. Like O and NNN, WPC is a triple net lease landlord. O and NNN, however, focus heavily on retail and are largely domestic players.
WPC's business spans retail, office, and industrial, and it operates globally (mostly in the United States and developed European markets). While on the surface that simply means it's a jack of all trades, it also gives WPC the flexibility to shift to where it sees the best opportunities. In the first half of this year that's meant buying mostly in Europe, where pricing was cheaper and financing costs were lower. It also shifts between property types.
Neither O nor NNN can do these things to the same degree because they don't have the foreign or sector diversification that WPC does. Diversification alone isn't the competitive advantage, but add in a management team that is willing to use its diversification to be an opportunistic acquirer and it is.
Outside The Box
Clearly, a company itself doesn't usually lead to a durable competitive advantage. There's more at play and that often means management teams and institutionalized approaches. Federal Realty (NYSE:FRT) is an excellent example. While most REITs focus on buying and operating property, FRT takes a slightly different approach. It describes what it owns as "developments."
And that's exactly what they are: long-term projects that expand over time. Sure, they are filled with buildings, but they aren't as simple as putting up an office and saying it's done. FRT focuses on creating mixed-use spaces that span the office, retail, and residential arenas. And because the projects are so long term in nature, it often has decades of growth built into each one it's working on. That helps explain why the REIT has increased its dividend annually for nearly 50 years.
Management can also be important in a different way. NNN is a great example here, because it takes a one-off approach to building its portfolio and focuses heavily on the relationships it builds with its tenants. It digs in and gets to know the details. That's helped it recently as prices for triple net lease properties have gone up - in the first half of the year, NNN sourced most of its acquisitions from current tenants. Moreover, by working "off market," it was able to get better prices. While it can be hard to quantify a good management team and distinctive corporate culture, over time it will show up if you look for it.
Why Is This Important Now?
REITs have gone through a period in which investor demand for yield has led to all boats rising. So good and bad have done well. But long-term investors should want to own the better companies.
At this point, the market appears to be pushing away from the REIT sector with the same lack of care with which it jumped into the sector. That's likely to mean throwing the baby out with the bathwater. So even good REITs will get hurt.
But eventually, quality will win out. As the market starts to distinguish more and more between good REITs and bad ones, it will be the good ones that will stand apart from the pack. So, now is the time to start making your list and looking for the moat, or durable competitive advantage, that gives a REIT an edge. If you have that list in advance, you'll be able to pull the trigger when you see a great sales price.
Disclosure: I am/we are long O, VER.
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.