4 Rotten REIT Eggs Your Basket Doesn't Need

Includes: AFIN, CBL, GNL, WPG
by: Brad Thomas

There's no such thing as a "too good to fail" investment.

We investors have a very bad habit of putting our full faith, trust, and money into a particular idea.

We're drawn to the appeal of pirates, you might say.

Whether they mean it or not, bad investments can behave exactly like pirates.

Looking at the real estate investment trusts, or REITs, that I'm detailing today, I'm reminded of Pirates of the Caribbean. The first one, to be precise.

If that sounds rather strange, bear with me. It will all make sense well before we introduce our four rapscallion investment opportunities.

(For the record No. 1: "Rapscallion" isn't an endearing term, no matter how much fun it is to say out loud.)

As a general rule, I'm a huge proponent of REITs, as anyone who regularly reads my articles or otherwise follows me has to recognize. They're the love of my investing life due to their diversification qualities, the exact details of their tax-exempt status, and the steady dividend opportunities they offer.

The real estate investment trust model is a strong and solid one that I'm more than happy to get behind.

However, that doesn't mean I'm going to approve of every single REIT I come across. I'm not a REIT ideologue, and as much as I appreciate these investment vehicles, they don't form the basis of a religion for me.

Investments never should.

That's because there is no such thing as a too-good-to-fail investment. There's always some way they can let you down. It's only a matter of how likely that possibility may be.

(For the record No. 2: The four REITs in this article have a very, very, very high probability of doing exactly that.)

You'd think we would have learned this lesson by now after Enron, after the financial crash, and/or after Bernie Madoff. But we haven't.

Instead, we investors have a very bad habit of putting our full faith, trust, and money into a particular idea, whether that idea is a company, an investment classification, or a sector. And we continue to do that no matter how many times we're shown how painful the results can be.

We're drawn to the appeal of pirates, you might say.

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Really Bad Eggs

Clearly then, this brings us right back to the movie, Pirates of the Caribbean - Curse of the Black Pearl.

The film features a song by the legendary Hans Zimmer, a German film score composer whose work has received numerous impressive recognitions, including Grammy Awards, Classical BRIT Awards, Golden Globes, and an Academy Award.

When it comes to music, this man knows what he's doing.

His genius shows in such movies as The Lion King, Gladiator, Pearl Harbor, 12 Years a Slave and many, many more moving stories. Yet for all the majesty ingrained in those soundtracks, it's one of his sillier creations that's running through my head right now.

Since you probably know it yourself, prepare for it to get stuck in your head as well.

"Drink Up Me Hearties" might be featured across all five Pirates movies. I wouldn't know since I didn't watch them all.

(For the record No. 3: There's a certain point when even the best storylines should be put to bed already, no matter how much money it's made in the past.)

What I do know is that it was most definitely featured in the one that started it all, Pirates of the Caribbean: The Curse of the Black Pearl. According to MetroLyrics, here's how the full song goes:

Yo ho, yo ho, a pirates life for me. We pillage, we plunder, we rifle, we loot; Drink up, me 'earties, yo ho. We kidnap and ravage and don't give a hoot; Drink up me 'earties, yo ho.

Yo ho, yo ho, a pirate's life for me. We extort, we pilfer, we filch, and sack; Drink up, me 'earties, yo ho. Maraud and embezzle, and even high-jack; Drink up, me 'earties, yo ho.

Yo ho, yo ho, a pirate's life for me. We kindle and char, inflame and ignite; Drink up, me 'earties, yo ho. We burn up the city, we're really a fright; Drink up, me 'earties, yo ho.

We're rascals, scoundrels, villains, and knaves; Drink up, me 'earties, yo ho. We're devils and black sheep, really bad eggs; Drink up, me 'earties, yo ho.

Yo ho, yo ho, a pirate's life for me. We're beggars and blighters, ne'er-do-well cads; Drink up, me 'earties, yo ho. Aye, but we're loved by our mommies and dads; Drink up, me 'earties, yo ho.

I've never heard that last verse before, so who knows if some yahoo threw it in there after making it up on the spot. However, the rest of it sounds about right for the four REITs we're about to take a cutlass to.

Prepare to be shocked and appalled at what we find.

Whether Pirates, Privateers, or Simply Buffoons, You'll Want to Steer Clear

Whether they mean it or not, bad investments can behave exactly like pirates. They take what they can get from you and then leave you hanging high and dry… or perhaps walking the plank to some watery fate you'd really rather avoid.

Take Global Net Lease (GNL) for starters. This externally-managed REIT owns free-standing net lease properties. Sounds simple, right?

With a portfolio of more than 330 properties (106 tenants doing business in 42 industries), this REIT is heavy in office (around 55% of the portfolio), recognizing that these properties require significantly more capital ("capex") for tenant upfits, leasing commissions, and re-leasing costs.

It's true, GNL's average lease duration is around nine years, however, most REITs with office exposure maintain lower AFFO payout ratios to provide an adequate margin of safety in the event of a tenant default or early vacancy. To add to that pain, GNL has just under 50% of its investments located outside of the U.S. and last year the company severed ties with its European partner, Moor Park.

We're not convinced GNL can maintain its current dividend of $2.13 per share (it has never increased the dividend since inception) as the forecasted AFFO per share for 2019 (according to FAST Graphs) is $1.99 per share. That means GNL's payout ratio is 107% so the company has to "steal from Peter to pay Paul."

Another pimple ready to pop (had to use this analogy, don't eat too much chocolate) is American Finance Trust (AFIN), also externally-managed by the same manager as Global Net Lease. The company listed shares last July (2018) and since that timeshares have drastically underperformed (-31%).

If you think the 10.2% is tempting, wait!

This REIT listed for one reason: It had no choice. The company was previously a non-traded REIT and it did it to create liquidity. With a portfolio of around 560 properties (over 7.5 million square feet), the properties consist of single tenant retail, distribution, office, power centers, and lifestyle centers (around 74% of the portfolio is retail).

Don't get confused with the fact this REIT is diversified, because the company has significant exposure to SunTrust Bank (STI), and with a planned merger with BB&T (BBT) it's likely many of these branches will go dark. Also, given AFIN's high cost of capital, the company has been forced to acquire properties with higher cap rates (much more risk).

There's no real moat for AFIN, and while the company does pay monthly dividends, intelligent investors should take a closer look at the payout ratio. Similar to GNL, AFIN has a dangerous payout ratio (of 108%). The annual dividend forecasted by FAST Graphs is $1.10 per share and the AFFO per share (forecast is $1.02). There's no cushion here and we consider AFIN a "sucker yield" which simply means the yield is too good to be true.

Another high-yielding REIT to avoid is Washington Prime (WPG) that has yet to cut its dividend (of $1.00 per share), but Mr. Market is signaling the likely future impact. Shares now trade at $4.83 with a dividend yield of 20.7%. The REIT's dividend payout has been frozen since 2015. That points to some major issues regarding the prospects for improvement.

The challenge is that Washington Prime faces issues with high redevelopment costs, and although the company has budgeted for the necessary costs to re-tenant vacant storefronts, there's no clarity as to future store closures. As Michael Boyd pointed out recently:

"Goldman Sachs analyst Caitlin Burrows already zeroed in on this aspect in the Q4 conference call, stating that "…based on the pieces of guidance that you guys gave as it relates to FFO and then CapEx and then redevelopments then it does seem like that the ability to cover the dividend in 2019 is kind of not there." That's true and illustrated above."

We consider Washington Prime a sucker yield (just like GNL and AFIN) and this simply means that the 20% dividend yield is not sustainable. We believe there's a 50-50 chance of a cut in 2019 and a 75% chance in 2020.

Finally, our stinky REIT award goes out to CBL Properties (CBL), a struggling mall REIT that has been virtually boxed in with very few options. The clock is ticking for CBL as its credit facility matures in July 2023 - "right before the first swath of unsecured bonds." As Michal Boyd explains, "this essentially moves the goalposts out for the bear camp several years, the next challenge will be rolling over unsecured debt at reasonable rates."

Boyd adds that "creditors have increased their stranglehold on corporate control, limiting operational flexibility" (for CBL) and "whether that contributes to the lack of SSNOI/FFO growth (or even stabilization would be nice) is debatable."

CBL will definitely see FFO shrink - again - after redevelopment benefits cannot offset the portfolio run off. After multiple dividend cuts, Boyd adds that "the common stock is uninvestable." The preferreds carry risk as well, but at this point, investors should at least collect those (preferred) checks until 2023.

In Closing: Pick Out Some Golden Eggs

We must caution investors not to chase yield. Over the years we have assisted thousands of investors by calling out the sucker yields and value traps and our business model of selecting sound REIT securities purchased at a wide margin of safety has proven to provide superior results over the long term.

REITs help to diversify a portfolio because, as real estate, they are a distinct asset class that has demonstrated low to moderate correlation with other sectors of the stock market, as well as bonds and other assets.

REIT returns have tended to zig while returns of other assets have zagged, smoothing a diversified portfolio's overall volatility. This diversification may help an investor increase long-term portfolio returns without taking on additional risk, and that helps intelligent investors sleep well at night.

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Stay tuned for my next "Lessons Learned" article on Diversification.

Author's note: Brad Thomas is a Wall Street writer, and that means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free, and the sole purpose for writing it is to assist with research, while also providing a forum for second-level thinking.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.