The Dark Side Of REIT Investments - Revisited

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Includes: GNL, HPT, MNR, OPI, RMR, SNH, WHLR
by: Jussi Askola
Summary

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

Dilutive growth, "fake value," and biased investment reports are among the common reasons that often lead to poor investment decisions.

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

We discuss one of our current top picks among small-cap REITs.

In a recent article entitled "The Dark Side of REIT Investments," I go on to explain that small-cap REITs present lucrative opportunities right now:

  • They trade at just 12x FFO compared to 20x FFO for comparable large-cap REITs.
  • They often enjoy greater growth prospects, despite the materially lower valuation.
  • Finally, they also pay greater dividends with a 6% average yield.

Higher growth combined with higher yield and lower valuation is a perfect recipe for spectacular returns. However, as you have probably already known:

There ain't no such thing as a free lunch."

And with small-cap REITs, investors have to be especially careful in their selection as there exists a "Dark Side" to small caps with:

  1. Self-interested and dishonest management teams in some cases.
  2. Higher volatility and significant disparities in performance.
  3. And lack of dedicated investment research.

Today, in an effort to take this discussion even further, we add three more issues to the list. Over the years, we have found that (1) dilutive growth, (2) fake value, and (3) biased investment reports are leading reasons for poor investment selection and results for the unsophisticated REIT investor.

The "Dark Side" of small-cap REITs is a real thing, and if you want to avoid stepping on a landmine, you better be aware of the following issues and know how to dodge them:

#1 Dilutive Growth

Every REIT wants to grow to achieve greater scale and "notoriety." Management teams also are conflicted here because a larger portfolio size may justify higher salaries. This has often led to what we call "empire building" in that managers will seek to buy more and more properties with little regard to the dilutive impact of raising more capital.

Growth can be very profitable for shareholders if it happens on a "per share" basis - but it also can lead to very disappointing performance if the cost of capital exceeds the investment returns. In other words, it does not help to double FFO if you also double the share count - leading to stagnant or even declining FFO per share.

This type of behavior is unfortunately quite common in the small-cap space because these companies are less scrutinized by analysts and also may have greater difficulty in raising capital at reasonable cost. Fortunately, it's fairly simple to recognize the good apples from the bad ones.

  1. Stick with REITs that have high insider ownership. This will assure you that the manager has skin in the game and a lot to lose in causing "dilutive growth."
  2. External management agreements are not a deal breaker, but it's a red flag. Externally-managed REITs tend to suffer greater conflicts of interest and have historically been more affected by dilutive growth.
  3. Trust but verify. If a REIT suddenly starts raising more equity, but its share price is at a very low level (high yield and/or discount to NAV) - this may be a good indicator of pain ahead.

The RMR-managed (RMR) REIT entities are a good example of past dilutive growth behavior: Senior Housing Properties (SNH), Hospitality Properties Trust (HPT), Office Properties Income (OPI) and Global Net Lease (GNL), to name a few.

#2 Fake Value

Just because a REIT trades at a low FFO multiple does not automatically mean that it's undervalued by any means. Small-cap REITs trade today at 12x FFO which is very inexpensive when compared to larger peers:

small cap REITs

source

If you eliminate the few outliers such as Innovative Properties (OTCPK:INNPF) that trade at ~35x FFO, we can get the average closer to 10x FFO (or a 10% FFO yield).

This is cheap - however - many of these "seemingly" undervalued REITs are nothing more than overleveraged, poorly managed time bombs that should be avoided at all cost in a late cycle economy. When a REIT trades at a low FFO multiple, say 8x FFO, but it's not undervalued - we call it "fake value." Wheeler Real Estate (WHLR) is a perfect example of just that. Back in 2016, the company attracted a lot of investors due to its unusually high dividend yield and low FFO multiple relative to peers.

Three years later, many investors got a taste of what "Fake Value" really is:

reits and conflicts of interest

This is not to imply that we never make such mistakes (we sure have!). But it's through these mistakes that have learned how to spot such dangerous situations.

#3 Biased Research Reports

Finally, investment research on small-cap REIT opportunities is rare and its objectiveness is often questionable. I have found that small-cap REITs always are eager to get attention from investors and will often directly reach out to analysts (including me) in an attempt to sweet talk them into giving a positive review of the company.

By sweet talk, I do not mean anything more than a phone call or invitation to an event, but nonetheless, it will often have an impact (generally positive) on the analyst's views who may then write a biased investment report.

Since we represent ~400 REIT investors at High Yield Landlord, we are often directly approached by REIT management teams who wish we would give them the green light. We always welcome discussions, but we are also very careful to not let any biases influence our thinking. We suspect that this is not the case for everyone. (Disclosure: the objective of High Yield Landlord is to streamline our REIT research process to the public and allow interested members to emulate our strategy.)

Even worse than some sweet talk, there exists an entire industry of "company-sponsored research" in which REITs will pay analysts to produce and distribute "independent research" on their companies. It should be clear to everyone that it leads to sizable conflicts, and while it's strictly forbidden on the Seeking Alpha website (fortunately!) - it remains a common practice in the research industry.

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

A good small-cap REIT opportunity is one that trades at a sizable discount to larger peers, but most importantly:

  1. Does not partake in dilutive growth.
  2. Is conservatively financed.
  3. And well managed in the shareholder's best interest.

This is a sector where you need to be very selective to maximize returns and avoid landmines. As an example, 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. Here's one small-cap REIT that passed our selection process and in which we have recently invested: Monmouth Real Estate (MNR).

Put shortly, MNR is a small-cap industrial REIT ($1.3 billion market cap) that recently traded down for reasons that we believe to be unwarranted. As a result, the company has become undervalued at just around 13.5x FFO while its closest peers trade at closer to 22x FFO.

There's no reason to justify a discount of this magnitude. In fact, we consider MNR to be one of the highest-quality REITs in the world:

  • Its track record is exceptionally strong: MNR ranks in the top 15 REITs in terms of total returns in the past 10 years and it has never cut its dividend, not even in 2008.
  • The portfolio quality is among the best in its sector: Youngest assets, class A quality, consistently high retention rate, longest average lease term at eight years.
  • The balance sheet is conservative: The LTV is at ~35% and the company enjoys the longest average debt maturity at over 10 years!

FedEx Ground, Mesquite - Typical property owned by MNR:

fedex industrial investment

We believe that the recent underperformance that led to this mispricing is only temporary and will lead to a recovery with ~20% upside potential already in the near term. As we wait for the mispricing to correct itself, we sleep well at night knowing that we own Class A assets that are conservatively financed and earn a very defensive 5% dividend yield that has never been cut, not even during the great financial crisis.

The company has historically been a strong outperformer with 3x higher total returns than REIT benchmarks in the past 12 years:

Monmouth outperforms

And yet, the company continues to trade at a massive discount to peers - for reasons that we believe to be totally unwarranted. We were able to build a position at a ~7% lower share price, but even now, the company remains very opportunistic.

It's by targeting this type of high-quality undervalued small-cap REITs that we aim to outperform the passive REIT indexes - all while earning higher dividends. As of today, our Core Portfolio has a dividend yield of 7.2% with a conservative 68% payout ratio despite a yield that's 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).

high yield landlord portfolio

Source: High Yield Landlord Real-Money Portfolio

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

Priced at a deep discount to larger REITs, there's no doubt that there exist some lucrative opportunities in the more obscure and less crowded small-cap space. You must, however, exercise very prudent attention to your selection as return disparities can be massive.

To illustrate this point, consider that 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:

average investor performance

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

Disclosure: I am/we are long 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.