REIT Investors: The 5 Investment Rules You Should Know

|
Includes: AMT, CCI, CORR, CTT, EPR, FPI, GLPI, HPT, HYG, IIPR, ILPT, IWF, IWM, LAMR, LAND, MGP, MPW, O, OHI, OPI, OUT, PCH, RMR, RYN, SNH, SPY, UNIT, VICI, VNQ, WPG, WY, XLU
by: Jussi Askola
Summary

If you know what you are doing you may outperform passive indexes, possibly by a wide margin.

We specialize in REIT investing and have identified five simple investment rules that lead to alpha-rich returns.

Some discussion on what the ideal REIT investment opportunity looks like in our eyes.

REITs have a long history of producing market-beating returns along with high dividend payments and only moderate risk. Therefore, most investors understand that they should invest in REITs whether it's for:

  • High current income.
  • Long-term appreciation.
  • Inflation protection.
  • Or diversification.

In fact, in the past 20 years, REITs had the very best performance among 10 major asset classes including large-cap stocks (SPY), value stocks (IWM), growth stocks (IWF), utilities (XLU), and high-yield bonds (HYG), etc.

source

The more difficult question to answer is how to invest in REITs? When looking at all the different strategies, most investors consider two main options:

  • Option 1: Invest in a REIT index fund (passive)
  • Option 2: Invest in individual REITs and build a Portfolio (active)

For "know-nothing investors,” to borrow a term from Charlie Munger, the easiest option 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" 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.

Active REIT investors have historically managed to outperform passive benchmarks by 100-200 basis points per year on average (after fees) and the best value investors have reached up to 22% annual returns over the same time period:

Source

This is what we strive to achieve. We are not content with the “average” results and low dividend yields of index funds. We believe that with some simple rules and a strict selection process, we can achieve superior total returns along with higher dividend income over time.

Below, we share five investment rules that we expect to result in higher total returns for active REIT investors:

Rule #1 - Focus on Underpriced Small-Cap REITs and Avoid Overpriced Large Caps

While most investors blindly invest in large-cap mainstream REITs with little chance of generating alpha, we believe that we have a head start by focusing on the less crowded, yet more lucrative small-cap segment where quality fundamental research can be profitable.

Today, large-cap REITs trade at 20x FFO which is about fair value in our opinion. In comparison, small caps trade at just around 12x FFO – or a 40% discount to larger peers.

source

We believe that this creates an opportunity for the more entrepreneurial investors who are willing to do some digging because there's no valid reason to justify such a large valuation differential.

Going forward, it creates an asymmetrical risk-to-reward outcome for small-cap REITs because they enjoy greater appreciation potential and margin of safety.

Rule #2 – Overweight Specialty REITs That Produce Alpha-rich Strategies

Specialty REITs come in many different shapes and forms. In recent years, there has been an emergence of many new specialty REITs targeting non-traditional property types including:

Since fewer investors are chasing opportunities in specialty sectors, cap rates tend to be much greater, lease terms are stronger, and tenant turnover is commonly lower. It often leads to stronger total returns over time. EPR Properties (EPR) is a good example of that:

Finally, specialty REITs can offer valuable diversification benefits because their fundamentals are not directly correlated with traditional property sectors including retail, industrial, office and residential.

We take advantage of this lower correlation to improve the risk-to-reward profile of our diversified real estate portfolio.

Rule #3 – Skip the Externally-managed REITs

Exceptions exist, but generally speaking, externally-managed REITs suffer from greater conflicts of interest, have greater G&A cost, and shareholder returns have been significantly lower over time. The reasons that led to underperformance in the past remain perfectly relevant today and we do not expect future results to be drastically different.

Therefore, by simply skipping all the externally managed REITs, investors can improve their expected returns as compared to Index funds that hold exposure to many externally managed REITs.

Even if an externally-managed REIT is very cheap - it does not necessarily become worthy of an investment candidate if we cannot rely on the management and its integrity. This has allowed us to avoid numerous serial underperformers such as the RMR (RMR) managed entities (SNH) (HPT) (ILPT) (OPI) that cannot be trusted.

Rule #4 – Adopt the Landlord Mindset

In a world where most analysts are focused on the next quarter’s earnings, our “landlord” mindset is what differentiate us from the rest. We see REITs as real estate investments, and NOT as stocks. We are real estate owners, not “stock market traders.” We mind fundamental performance of the properties, and NOT the short-term share price performance.

By adopting this mindset, we believe that REIT investors can improve performance as it leads to a more disciplined approach with less trading and more compounding.

Rule #5 – Target REITs Trading at Discounts-to-NAV

There exists massive disparities in REIT valuations with some trading a massive premiums to NAV while others trade at large discounts to NAV. Today, several REITs trade at over 50% premiums including Realty income (O), Omega Healthcare (OHI) and Innovative Industrial (IIPR).

According our experience (and academic studies), such lofty valuations lead to poor investment results in the long run. Conversely, REITs trading at discounts to NAV have historically produced superior returns. It's just common sense that buying real estate for materially less than what it's worth is a strategy that can result outsized cash flow and appreciation in the long run.

As such, we target primarily REITs that trade at sizable discounts to NAV. We believe that this “value” approach to REIT investing will continue to produce alpha-rich returns because:

  1. We enjoy greater margin of safety by buying below intrinsic value.
  2. We have superior appreciation potential.
  3. While we wait, we enjoy a greater cash flow yield.

Each investment won’t perform well by following this approach (e.g WPG) but a well-diversified portfolio is expected to outperform indexes in the long run.

Our portfolio is today priced on average at an estimated ~19% discount to NAV - meaning that each dollar invested in our selected REITs buys us $1.23 worth of real estate.

Ideal Investment Target for Outperformance

Back in May 2018, Medical Properties Trust (MPW) traded at an estimated ~20% discount to NAV and a 7.7% dividend yield. In hindsight, this was a fantastic opportunity for active REIT investors because it fits perfectly with the five previously discussed investment rules:

  1. It's not a widely followed large cap.
  2. It owns alpha-rich specialty assets.
  3. It's not poorly managed by an external management team.
  4. It fits well in the portfolio of a "landlord" with a long-term orientation.
  5. It traded at a hefty discount to NAV despite strong qualities.

Since presenting our thesis, MPW has returned upward of 50% compared to 18% for the REIT Index over the past year:

Passive vs. Active Investing: Decide Wisely

Whether you decide to invest in an index fund or venture into building your own portfolio of undervalued REITs, you should know your limits.

Quite frankly, if you know that you have little access to research, do not possess the expertise, or the time, you will most likely be better off going the index route.

However, if you know what you are doing, have access to quality insights on the best opportunities of the moment, and are not scared to occasionally open an annual report, then the reward potential can be drastically improved.

Disclosure: I am/we are long MPW; EPR; UNIT; WY. 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.