The Dark Side Of REIT Investments

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Includes: AUM, BRT, GNL, HPT, HT, ILPT, LXP, MNR, O, OLP, OPI, RMR, SNH
by: Jussi Askola
Summary

All things considered; REITs are my favorite asset class for long-term oriented income investments.

Opportunities are abundant in the small-cap segment, but you must be really careful to not step on a landmine.

The management team can be your friend, but also your enemy.

Know your limits. If you lack an edge, go with well-diversified indexes funds or ETFs.

With a strict selection of the best REITs, most of the landmines can be avoided and investment performance can be materially improved.

In a recent article entitled “The Big Opportunity of 2019,” I go on to explain that small-cap REITs present a lucrative opportunity for high-yielding investments right now. This is because:

  • The difference in valuation between small-cap REITs and large-cap REITs has rarely been this large. While large caps trade at 20x FFO, small caps trade at just around 12x FFO – or a 40% discount to larger peers.
  • The massive discount is not justified by fundamental factors, but rather by the discriminate flow of index money towards large caps.
  • Small-cap REITs are in a favorable spot to generate superior returns with higher income, faster growth and better downside protection.

With that said, it's important to recognize that “not all REITs are created equal” and this applies particularly well to the small cap segment of the market.

These REITs have less institutional scrutiny and risks can often go unnoticed. Management teams are often self interested, the lack of scale can lead of value destruction, and excessive risk taking is rampant. Needless to say that this is a sector where you need to be very selective to maximize returns and avoid landmines. As an example, at High Yield Landlord, for every investment that we make, we reject about 10 other alternatives:

Small-cap REITs can provide ample rewards to those willing to put in the work, but they also can be remarkably unforgiving to those who ignore the problems.

Below we discuss the "dark side" of small- cap REITs and explain how we seek to avoid landmines.

#1 Self-Interested Management and Conflicts of Interest

The REIT industry has greatly improved for the better in the past decades. Back in the 70s, it was not uncommon 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, especially in the small-cap segment, that keep acting in their self interest. Managements are more worried about their own pay than the performance of the underlying stock. The good thing here is that these REITs are fairly easy to identify:

  1. They will often have an external management agreement.
  2. The managers will have little skin in the game other than their salary.
  3. The REIT will not hesitate to issue shares at a discount to NAV.
  4. The fees will be directly tied to the assets under management (AUM).

This leads to what we like to call “empire building.” In other words, they will seek “growth at all cost” and dilute the current shareholders just to grow an ever larger pie to justify higher fees.

While this practice is relatively rare in the highly scrutinized world of large caps, investors must pay very careful attention when investing in small cap REITs. Even if a REIT is cheap - it does not make it an investment candidate if we cannot rely on management’s integrity. This has allowed us to avoid numerous serial underperformers such as the RMR-managed (RMR) entities (SNH) ( HPT) (ILPT) (OPI) to name a few.

#2 High Volatility and Disparities in Performance

It's not a secret to anyone that small caps tend to be more volatile than larger companies. While this often leads to opportunities, investors should know that it can be a bumpy ride – and the actions of the management team have significant influence on the volatility.

Actions that lead to greater volatility in the small-cap space:

  • Issuing shares at discount to NAV such as GNL (GNL) does.
  • Overleveraging the balance sheet such as BTR (BRT) does.
  • Any action that causes temporary disruption to cash flow such as the portfolio repositioning of Lexington Realty (LXP).

Actions that lead to lower volatility in the small cap space:

  • Appropriately timed buy-backs such as Hersha (HT).
  • Reasonable capital structure such as Monmouth (MNR).
  • A greater focus on rent collection from quality assets rather than asset repositioning and redevelopment.

Anything that leads to shakier fundamentals will lead to wider price fluctuations, and when dealing with small caps, every management action has an amplified effect on the price.

Small Cap REIT investors are very impatient and will trade in and out of their positions based on the next quarter’s outlook – causing massive disparities in performance. To maximize your chances of being on the right side of the trade, it pays to keep a close eye on the actions of management.

#3 Lack of Dedicated Investment Research

Today, the average large-cap REIT has more than 700 institutional investors on board, whereas small-cap peers have less than 200. Moreover, while large caps are on the coverage list of 9 professional analysts on average, small cap commonly have 2 or less, in some cases zero coverage.

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The consequence for investors, especially individuals, is that it becomes very difficult and expensive to access quality research on these opportunities. Analyzing small-cap REITs is no walk in the park and it requires specialist skills that are not widely available.

My point here is that you must know your limits. If you lack an edge, go with well-diversified indexes funds or ETFs to avoid stepping on the landmines.

I hand pick my small-cap REIT investments because I'm a professional analyst, I do this full time, and have access to detailed research on small cap opportunities and management interviews through my affiliation with High Yield Landlord. (Disclosure: the objective of High Yield Landlord is to streamline this research process to the public and allow interested members to emulate our strategy.)

However, it should be clear that this is not for everyone. It's preferable to go with an index that will assure you diverse exposure to an opportunistic sector, rather than try and make your own selection if you have limited access to resources (time, capital and expertise).

Small-Cap REIT Investment Idea - An Example of a Good Opportunity

To put theory into practice, we present one small cap REIT that we are currently eyeing for a future potential investment: One Liberty Properties (OLP).

With its small $500 million market cap, the REIT is not gaining much attention from the crowd. But for those who are willing to check under the hood, there is a lot value here.

OLP is a net lease REIT, just like Realty Income (O), but rather than trade at 22x FFO, OLP is currently offered at around 12x FFO - a full 10-turn lower multiple than the popular large cap. The massive discount lets you assume that the company must have some serious issues, but the reality is that this is a quality company and it does not present any of the previously mentioned problems:

  • The management owns 22% of the shares - Assuring interest-alignment and a strong focus on shareholder-friendly management.
  • The portfolio is diverse with the largest exposure to high-demand industrial properties at 37.5% of the rental income. The average remaining lease term is over eight years - providing consistent cash flow for years to come. Finally, the balance sheet is adequately structured.

The company has significantly outperformed the REIT market in the past 10 years with total returns reaching 13.5% compared to 7.9% for the average REIT:

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Moreover, the company yields a hefty 6.7% and the dividend is on the rise:

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The point here is not to argue that OLP deserves to trade at the same valuation as Realty Income because it does not. But given the high quality nature of the operations, the strong track record and the sector-leading management alignment, we believe that OLP is a good example of the type of small-cap REIT that we like to target.

By building a well-structured portfolio of small cap REITs, we believe that investors can outperform larger caps and earn greater income.

As of today, our Core Portfolio has a dividend yield of 7.2% with a conservative 68% payout ratio despite a yield that is almost double the index. Beyond the dividends, the core holdings are trading substantially below intrinsic value at just 9.5x FFO – providing both margin of safety and capital appreciation potential (REITs trade on average at over 18x FFO).

Source: High Yield Landlord Real-Money Portfolio

Closing Notes: REITs Are Wonderful (if you pick the right ones…)

Priced at a 40% discount to larger REITs, there's no doubt that there exist some lucrative opportunities in the less crowded and more obscure small cap space.

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You must however exercise very prudent attention to your selection of individual investments as return disparities can be massive.

To illustrate this point, consider the following: The best REIT investors have achieved up to 22% annual returns over the past decades, whereas the average individual investor earned only 2.6% per year over the same time frame:

Clearly, the average investor does NOT know what they are doing. They are consistently making the wrong decisions, trading too much, and stepping on landmines.

Disclosure: I am/we are long HT; MNR. 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.