Co-produced with Samuel Smith for High Yield Landlord
At High Yield Landlord, we invest a large percentage of our net worth into real estate for two reasons:
- We believe that it is one of the easiest business models to understand (thereby minimizing mistakes) with some of the best passive investing opportunities available; and
- because we believe it is the best asset class for long-term investing, especially when building a million-dollar portfolio for generating low-risk, inflation-resistant passive income.
Source: High Yield Landlord Real Money Portfolio
Today our real-money REIT portfolio stands at just over $65,000, the beginning stages of our long-term goal of reaching $1,000,000 in REIT investments. At our current weighted average dividend yield, such a portfolio would provide over $77,000 in annual passive income with a payout ratio of just 73.8%. This illustrates the power of REITs to provide lucrative and fairly safe passive income.
As we have written about previously, we have a strong preference for investing this portion of our wealth into REITs rather than individual properties as well as into publicly traded vehicles rather than private market REITs due to the numerous advantages they offer such as economies of scale, safety through broad diversification, easy liquidity, professional management, total passivity, and transparency leading to better risk-and-hassle-adjusted returns over the long run. In addition to these benefits, there is another important reason that we also favor publicly-traded REITs over privately-traded REITs: Despite the increasing efficiencies of public markets, Mr. Market still routinely offers compelling bargains, and we believe that the publicly-traded REIT sector is one of the easiest and surest ways to spot and capitalize on these opportunities. As a result, publicly traded REITs offer the best of everything that real estate has to offer without many of the downsides, making it one of the best passive investing vehicles available.
Not only are publicly traded REITs one of the best passive investing vehicles available, but they are also one of the best risk-adjusted long-term investments you can make due to the fact that real estate will always be necessary and limited.
Regardless of technological innovation, real estate will always be needed to sustain and enhance human life and - as the human population continues to grow - it is becoming increasingly rare on a per-person basis. Additionally, the REIT business model is much more stable than many other business models, making REITs less speculative.
Why is this? Well, while many businesses (and therefore their stocks, such as those found in the S&P 500 (SPY)) come and go, well-located real estate assets (and therefore their stocks, i.e., REITs like those found in the Vanguard REIT Index Fund (VNQ)) are here to stay. Landlords cash rent check after rent check regardless of the occasional tenant bankruptcies and/or ups and downs of the market. This is clearly being demonstrated during the ongoing "retail apocalypse" in which many retailers are going bankrupt, but retail landlords are merely struggling at worst (such as CBL Properties (CBL) and to a lesser extent Washington Prime (WPG)) though many continue to do just fine, if not thrive (i.e., Taubman Centers (TCO), Simon Property Group (SPG), Kimco Realty (KIM), Federal Realty Trust (FRT), Acadia Realty (AKR) and Brixmor Property (BRX)). This is why we seek to take a safer investment position by owning the properties that businesses occupy rather than the businesses themselves.
The distinction makes a big difference because unlike most businesses, landlords benefit from many risk-mitigating factors that allow them to earn much more consistent and predictable income over time.
- First of all, landlords participate in the profit earned by their tenants through rents that are contractually guaranteed - often for many years to come.
- Second, landlords get paid first. Without a rent payment, a business cannot keep operating and therefore rents are even senior to debt payments in most cases.
- Third, in the worst case where a tenant goes bankrupt, landlords can simply release the same property to another tenant. The value of the previous tenant's business may go to 0, but the landlord is in a much safer and stronger position to sustain value.
- Fourth, as a scarce supply and essential part of our infrastructure, real estate provides superior inflation protection - an important risk that should not be overlooked in today's market environment.
Since their cash flows are typically less volatile than stocks due to their revenues normally being backed by long-term leases, disruption to earnings power would require a major industry shift and/or tenants going out of business for a REIT to lose occupancy. While this certainly occurs, it is easier to spot and predict than say how many iPhones or electric vehicles a company will sell in a given quarter or year. Real estate as a business sector maintains a natural moat due to its limited supply yet guaranteed demand for commercial and residential needs. It is also fairly easy to understand, given its low-tech nature and the relatively simplified business model. These qualities, combined with the high payout ratios and low price to NAV of the vast majority of REITs, make them much easier to value and hold for the long term than stocks.
Our Strategy to REIT Investing
When investing in a REIT, it is important to remember that, given their high payout ratios, you are buying the dividend income stream. While it is true that inflation and the small amount of retained cash flows should lead to principal appreciation over the long term, the investing model is set up such that the majority of returns will likely come from the dividend stream. While this limited upside may turn more speculative high growth investors away, conservative value investors in the mold of Benjamin Graham, with a high regard for consistent, inflation-hedged compounding and a strong distaste for speculation, should be thrilled.
Focusing on the dividend stream means ignoring the scoreboard (i.e., the share price) and instead looking at the playing field (the actual performance of the REIT which translates into the risk-reward prospects of the dividend).
- Does the current yield combine with the REIT's dividend growth history and growth runway (i.e., payout ratio and FFO growth projection) to offer satisfactory returns?
- Is the business model sustainable - i.e., is the industry being disrupted and/or are a significant percentage of tenants at risk of bankruptcy/downsizing?
- If so, does management have a plan to adapt?
By weighing these factors, investors can make intelligent valuations of REITs and hold for the long term through the waves of market volatility. As long as the dividend is consistently sustained/grown, the share price will do just fine over the long term.
While REITs' exposure to the volatility of public markets can, and does, scare many investors into selling their holdings during bear markets, the best approach for long-term success is to buy and hold strong and secure dividend performers (otherwise known as "SWANs") and use dividends/extra cash to capitalize on opportunities to buy lucrative income streams that Mr. Market has placed on the clearance rack. While we always prefer to buy SWANs ("Buffett" style REITs in that they enjoy a very strong and stable source of income via an identifiable moat selling at a reasonable price), in aging bull markets (like the current one), they can be difficult to find at attractive valuations, so we then turn to "Graham" style REITs: High-yield and/or low price-to-NAV value REITs that may be facing uncertainties but have a wide margin of safety due to an excessive market sell-off and can therefore give us a healthy profit within a year or two based on dividends plus a convergence back towards NAV. These REITs are not core portfolio members but rather short- to medium-term deep-value plays where we wait until we have reaped the delta between intrinsic value and the current market price and then sell. Given that these are higher-risk propositions, we always keep these holdings small relative to the rest of our portfolio. Furthermore, if given the choice between buying a SWAN for a fair price or a "Graham" REIT for a dirt cheap price, we will always take the SWAN.
Given that our target rate of return is 15% and the long-term national average annual rate of property appreciation is 3%, our target dividend yield is 7%. Factoring in leverage and capital recycling taken on by the REITs themselves plus our practice of selling fully-valued REITs in order to recycle capital into more attractive opportunities, gives us the additional 5%+ that we need to meet our target. However, in the case of REITs with strong dividend growth prospects (i.e., AFFO that could easily support a 7% yield but the funds are being used for growth projects and/or share buybacks) and/or steep discount to NAV, a 5% yield is acceptable for us.
Recent Investment Examples: Buffett vs. Graham REITs
An example of a blue chip "Buffett" style REIT that recently met our criteria was Brookfield Property REIT (BPR). It offered a yield north of 7%, had strong growth prospects, and numerous competitive advantages. It has thus far been the strongest performer among mall REITs in 2019 and remains a key component of our portfolio.
An example of an opportunistic deep value "Graham" style REIT that recently met our criteria was Brixmor. It was a company that had a below-average portfolio relative to its shopping center peers and resulting underperformance. Additionally, it was suffering from high leverage as well as its association with the negative sentiment being attached to retail. However, it was trading at a huge discount to NAV and had a clear plan for improving the portfolio and leverage quality that management was diligently executing on. As a result, we saw a tremendous opportunity to realize value in these shares and aggressively invested. Within half a year, we have reaped impressive profits and BRX is enjoying a run as the top shopping center REIT so far in 2019.
Our march to a one-million-dollar REIT portfolio will likely take us several years to reach and, in the process, we will almost certainly encounter numerous ups and downs. If there is a drawback to investing in publicly traded REITs, it is that we are exposed to daily volatility in price quotes on our shares. In contrast, private real estate investments would not make us aware of such daily volatility. Therefore, we may be tempted in times of heavy volatility to sell off our shares at inopportune times rather than hold them for the long run. As a result, we have established these ground rules to help us keep our emotions in check and stay on the right path by maintaining the mindset of a landlord investor:
- Simplicity: Only invest in businesses we understand (i.e., focus on real estate and similar real asset businesses).
- Income: Focus on the cash flow coming in knowing that as long as the dividend is maintained and/or grows over time, the share price will appreciate in the long run.
- Predictable: While we are prepared to weather volatility in the share price, we want assets that will generate consistent performance.
- Long-Term: Only buy assets that we would be happy holding for at least five years. This means that the REIT should have a sustainable business model with a balance sheet that can sustain distress.
Thanks for reading and we look forward to checking in regularly with progress updates on our portfolio!
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Disclosure: I am/we are long BPR, BRX,CBL, WPG. 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.