What’s your idea of a perfect investment?
That’s a tricky question, but those looking for above average current returns, along with reasonably good price appreciation prospects over time – and with only modest risk – will certainly want to consider apartment communities, office and industrial buildings, shopping centers, and other similar real estate investments. While some time ago, these highly profitable investments may have been reserved to high net worth individuals and institutions, it's today easier than ever before to invest in real estate through high-yielding real estate securities or REITs.
Just like mutual funds, they allow investors of all sorts to invest in real estate without actually having to go out and buy, manage and finance properties themselves. Even better, REITs have historically outperformed literally every other asset class including large-cap stocks (SPY), value stocks (IWM), growth stocks (IWF), utilities (XLU), high-yield bonds (HYG), and even private real estate.
Put simply, REITs are as close to the “perfect investment” as it gets. They are strong outperformers, pay higher income, and are less risky on average.
Yet, most people never invest in REITs because they simply do not know how to get started. The REIT market is very vast with more than 200 names – and it can easily get overwhelming to new investors. What makes it even more difficult is that each REIT is very unique in its structure, investment strategy, targeted properties, management quality, and balance sheet safety.
In this article, I attempt to summarize the 10 most important things that every REIT investor should know in less than 2,000 words. I believe that this article would have helped me a lot when I got started on my REIT journey 10 years ago.
Manhattan and its property investments ranging from office skyscrapers to shopping centers and luxurious condominiums:
#1 – Equity vs. Mortgage REITs
First off, it's important to distinguish between the two main categories of REITs: Equity REITs and mortgage REITs.
- Equity REITs – The majority of REITs are equity REITs. Equity REITs own and operate income-producing real estate investments. The market often refers to equity REITs simply as REITs.
- Mortgage REITs – Or mREITs provide financing for income-producing real estate by purchasing or originating mortgages and mortgage-backed securities and earning income from the interest on these investments.
Mortgage REITs are particularly popular among individual investors because they tend to pay higher dividend yields. However, investors should know that their total returns have been significantly lower over the long run.
The business model is closer to a “bank” than a property investment. Mortgage REITs earn their profit by sourcing capital at cost x – lending it at rate y – and earning the spread in between. It may work well for a time, but it's very sensitive to interest rate changes, and generally less desirable than owning the properties outright in the long run.
#2- A Lot of Property Types to Choose From
There exists a lot of different REIT sub-sectors:
- Net Lease
- Single Family Houses
- Manufactured Housing
- Shopping Center
- Mall Specialty
- Data Centers
- Home Financing
- Commercial Financing…
Each sector has its unique risk and return characteristics and picking the right sector at the right time can determine the success of a REIT investor.
As an example, net lease REITs may enjoy very consistent cash flow while hotel REITs get crushed in a recession. Knowing where the differences are can literally “make or break” your REIT investments.
#3 – External vs. Internal Management Team
REITs can be managed internally or externally, and this seemingly unimportant issue can lead to massive disparities in performance.
- Internally managed REITs: Hire their management as employees of the REIT.
- Externally managed REITs: Outsource the management to an external asset management company.
The preferred option is the internal structure in the majority of cases. 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. Good examples of serial underperformers are all the RMR (RMR) managed entities: Senior Housing Properties (SNH), Hospitality Properties (HPT), Industrial Logistics (ILPT) and Office Properties Income (OPI).
#4 – Internal vs. External Growth
REITs can achieve growth on two main fronts:
- Internal growth: NOI growth (rent and occupancy increases) of the current portfolio.
- External growth: Acquisition of new properties.
Investors should analyze growth from both perspectives to get a complete picture of the growth prospects. Internal growth is achieved if and when the REIT owns high-quality properties in desirable locations, then rents tend to rise as a result of the appreciating real estate value. Here investors should also assess (1) whether the current rents are below or above market rates, and (2) when the leases are set to expire.
External growth, on the other hand, is achieved when the REIT is able to acquire new properties at a positive spread over its cost of capital. Here it is key to have (1) a low cost of capital, (2) a low payout ratio, (3) and/or the capacity to expand the leverage ratio.
Successful REITs such as Realty Income (O) are able to consistent grow a ~5% per year by combining internal and external growth, whereas lower-quality REITs such as Global Net Lease (GNL) struggle to maintain stable cash flow.
#5 – Balance Sheet Quality
Just like private real estate investors, REITs use leverage when investing in real estate. REIT balance sheets are today stronger than ever before with historically low leverage, a focus on fixed rate debt, and long maturities.
This is, however, on "average," and there exists enormous disparities in balance sheet strength from one REIT to the other. Investors should have their eye on:
- Interest coverage
Leverage is a double edge sword, and while it may amplify returns greatly in an early market cycle, it also can crush investors during downturns, so make sure that your REIT investments enjoy the balance sheet that suits your risk tolerance.
#6 - Sectorial Resilience in a Recession
In a recession, almost every REIT lose in value, but there's huge differences in magnitude, with some sectors getting absolutely crushed while others only have limited volatility throughout the cycle.
For instance, hotel REITs lost 60% in 2008. During the same year, healthcare REITs only dropped by 12% because their cash flow was significantly more resilient to economic shocks. Taking some chips off the cyclical hotel REITs in 2005, 2006, or 2007 and reinvesting proceeds in more defensive healthcare REITs would have been prudent and greatly reduced the pain ahead, but the fear of "missing out" on the rapid gains of hotel REITs late in the cycle blinded many investors.
Studying the historical annual total return of different property sectors since 2008, we find three exceptionally resilient sectors:
- Storage: 5% total return in 2008 while the S&P 500 (SPY) lost 37%.
- Healthcare: Minus 12% total return in 2008.
- Net Lease: Minus 15% total return in 2008.
After a 10-year long bull cycle, these more resilient sectors should become increasingly appealing to REIT investors today.
#7 – The Valuation Methodologies
There are two main approaches to value REITs:
- P/FFO: Is a cash flow multiple that is used to evaluate at how many times the FFO (cash flow) the company is trading.
- P/NAV: Is a comparison of the public market valuation of the REIT and the underlying value of the properties.
There's great debates on whether one is better than the other, but P/FFO estimates are generally preferred by individual investors, while P/NAV are more commonly used by institutions and professional investors.
Most REITs have historically traded at a P/FFO multiple of 15-20x, and at a P/NAV of right around 0.95-1.05. In both cases, the lower the multiple, the better the value (ceteris paribus).
#8 – Growth vs. Value REIT Investments
There exist two main REIT investment strategies:
- Growth: Investors target rapidly-growing REITs such as American Tower (AMT). These REITs will pay very little dividend, 1.65% in this case, but generate consistent growth that results in share price appreciation.
- Value: Investors will seek to identify companies that are relatively undervalued due to temporary issues that are hopefully fixable over time. Contrary to growth REITs, these REITs will pay higher dividend yields, commonly upward of 6 to 10%, but enjoy less or no growth in the immediate turn.
Both approaches are equally valid and it mostly depends on what you are looking for. At High Yield Landlord, we specialize in value REIT investing and seek to generate an average 8% dividend yield to help retirees and other income investors fund their lifestyle through real estate investing. This would not be possible if we followed a “Growth” strategy.
#9 – Different Risk Profiles
In case it wasn’t clear yet, there exists great disparities in the risk profile of different REITs, and you should be careful to only invest in REITs that suit your risk profile.
You can spot high-risk REITs by looking for the following attributes:
- Portfolio: Lower quality properties with poor locations, short lease terms, high capex, non-credit tenants, declining occupancy.
- Management team: External management structure, conflicted interests, little to no insider ownership.
- Balance sheet: Significantly more leveraged than closest peers, variable rate debt, short and concentrated maturities.
If the above points do not apply, you are likely dealing with a higher quality (lower-risk) REIT.
#10 - Small Caps vs. Large Cap REITs
Finally, and perhaps most importantly, investors should know that the best opportunities are generally hidden in the obscure and under-followed small cap segment of the market.
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.
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.
Bonus #11 - Passive vs. Active Investing
Now that you have the basic knowledge on what REITs are, the next question is how to invest in them. Here are your 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:
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.
We have been playing this game for a long time and spend over $20,000 per year researching the market for the best REIT investment opportunities. With over 200 REITs to choose from, we are very selective and only invest in one out of 10 opportunities on average.
The objective of High Yield Landlord is to streamline this research process to the public and allow members to emulate our strategy at a tiny fraction of the cost. We are #1 Ranked in Real Estate with +300 members on Seeking Alpha.
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.