The Untold Truth About REIT Investments

Summary

• It is well-known that REITs are our favorite asset class for high-yielding total return investments.
• Nonetheless it is not all sunshine and rainbows. In this article, we highlight the dark side of the REIT market.
• With a strict selection of the best REITs, most of these downfalls can be avoided and investment performance can be materially improved.
• Looking for a portfolio of ideas like this one? Members of High Yield Landlord get exclusive access to our model portfolio. Start your free trial today »

In a recent article entitled “The Untold Truth About Rental Investments”, I go on to explain that the reality of rental investments is very different from their common perception. Rentals are commonly presented as low risk/high return investments with great passive income. In reality:

• They are very work intensive with managerial difficulties in managing the 3 Ts: tenants, toilet and trash.
• They are financed with extreme leverage - exposing investors to excessive risks.
• Finally, they are illiquid, concentrated investments with high transaction costs.

Moreover, rental investors tend to believe that they are able to earn much higher returns. Again, in reality, REITs have historically outperformed private real estate investments by up to ~4% per year for the past +25 years:

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By exposing these flaws of rental investments, I came to the conclusion that the great majority of investors should favor REIT investments over rental properties. REITs combine the positive attributes of stocks (liquidity and low transaction cost) with the benefits of real estate (higher income and total returns). They are completely passive investments, provide better diversification, and are managed by professionals.

Nonetheless there is another side to every story. REITs have their flaws as well; and while they are (by far) our favorite option for real estate investments, there is an untold truth to be told here as well. Upon the request of a follower, we go on to expose the often-forgotten dark side of REIT investments:

#1 REIT Management Teams: Dishonesty, Misalignment, and Overpay

The REIT industry has come a long way. Back in the 70s, it was very common for management teams to take advantage of shareholders by charging excessive fees and doing what was right for them. Over the years as the market kept on growing, REITs have become much friendlier to shareholders and today, most management teams are well-aligned with significant insider stakes and adequate pay for the value creation.

That said, there still exists a number of REITs that keep acting in their management's self-interest. They are more worried about their own pay than the performance of the underlying stock. The good thing here is that it is fairly easy to spot them:

1. Commonly they will be externally managed.
2. They will do regular share issuances despite the deep value of their shares.
3. Their fees / salaries will be directly tied to the assets under management (AUM).

This leads to what we like to call “empire building”. The management team will seek to maximize the “size” of the portfolio rather than its “performance” to increase their management fees which are tied to the size of the AUM. In the worst cases, the management teams will go as far to issue new shares at discounts to NAV to buy more properties – directly destroying shareholder value along the way. Examples of REITs that have fallen victim to this behavior in the past include Global Net Lease (GNL), Office Properties Income (OPI), Select Income (SIR), and many other.

#2 Market Inefficiencies: Volatility, Correlation and Interest Rates

Still to this day, REITs remain deeply misunderstood by the investment community, including professionals. Many people who traditionally invested in real estate often do not trust – or bother to understand the stock market, while most people who invest in stocks are uncomfortable with commercial real estate. Put differently, REITs tend to be perceived as stocks by real estate investors, and as real estate by stock investors. Being a hybrid from both, has made it difficult for investors to categorize REITs into one group and led to substantial biases as well as a general lack of interest from the investment community.

It results in regular market inefficiencies with excessive volatility and correlation to the broader stock market. Moreover, investors may at time become overly worried for unwarranted reasons (ex: interest rate hikes) and panic sell. For investors who are worried about short term performance, this is a great concern as their REIT holdings will fluctuate in value on a daily basis despite no changes in their fundamentals.

However, this is also an opportunity for smart and entrepreneurial REIT investors who may achieve alpha by taking advantage of the market inefficiencies to buy undervalued REITs when they come on sale, and sell overpriced REITs when the market gets overexcited.

#3 Investment Result Disparities: The Need for Professional Analysts

We often argue that managing rentals is a huge hassle. You have to deal with tenants, property maintenance, financing, and so on and so forth. Yet, analyzing REITs is no walk in the park either. It requires specialist skills that are not widely available and there is a strong need for professional research to sort out the worthwhile from the wobbly.

One easy option for REIT investing is to simply invest in the broader REIT market, utilizing an index fund such as the Vanguard REIT fund (VNQ). However, this means buying every REIT in the index, regardless of its current price, quality, prospects, or management. While “know-nothing investors” (to borrow a term from Charlie Munger) may find this broad diversification useful, we believe (as does Charlie Munger) that using an intelligent analysis of the qualitative and quantitative aspects of each REIT in order to pick and choose the most opportunistic investments will provide the best total-returns over the long term.

At High Yield Landlord, we spend hundreds of hours and thousands of dollars researching the REIT market in order to target the highest quality REITs that are being offered for sale by Mr. Market at low valuations. As a result, we are able to achieve superior dividend yields (currently 7.86% weighted average in our real-money portfolio) at sustainable dividend payout ratios (currently 70.4% weighted average in our real-money portfolio), thereby giving us strong current income (enabling us to capitalize on short term volatility by averaging down on top opportunities) and superior total returns over time.

This is not however possible for everyone. We do this full-time, it is our only focus, we have great resources, and access to management teams to conduct interviews. (Disclosure: the objective of High Yield Landlord is to streamline this research process to the public and allow interested members to emulate our strategy.)

The Bigger Picture: Why We Prefer REITs Over Rentals

Now that the untold truth of REIT investments has been told and everyone is aware of their flaws; it is important to keep an outlook on the bigger picture.

REITs have historically outperformed almost all other asset classes with spectacular returns over many market cycles. They provide consistent high income along with long term appreciation in a perfectly passive manner. Finally, investors enjoy high liquidity, inflation protection, and limited liability.

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While every investment has its flaws, there are reasons why REITs are our favorite asset class. Passive indexes have managed to provide +12.5% annual returns for decades. Active and more entrepreneurial investors who target market inefficiencies have managed to reach up to +22% annual returns over the same time period:

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This is what we aim to do at “High Yield Landlord” by specializing in REIT investing. We want to maximize our chances of generating high total returns with limited risk while remaining liquid and in control of our real estate investment. We believe that the best way to achieve this is by investing in REITs, not in private rental properties.

A Note about REIT Investing: To succeed as a REIT investor and earn high consistent income, we recommend to:

• Closely monitor your REITs, including quarterly NOI and FFO performance.
• Diversify your REIT portfolio with at least ten companies (there are over 200 publicly traded REITs so please be selective).
• Identify REITs with strong long-term fundamentals but affected by temporary challenges causing their valuation to decline and yields to rise.
• Be ready to take advantage of market volatility and look for opportunistic buying points.

Disclosure: I am/we are long ALL STOCKS IN CORE PORTFOLIO AT HIGH YIELD LANDLORD. 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.