When REITs Lead To Large Losses

|
Includes: AIRB, AMZN, CBL, HPT, ILPT, JCP, M, OPI, RMR, SNH, SNR, UNIT, VWORK, WPG
by: Jussi Askola
Summary

REITs are famous for being defensive income-producing investments.

There exists, however, a lot of landmines that can lead to massive losses.

We explore the most common reasons that lead to large losses in the REIT sector.

Finally, we present how we seek to avoid landmines at High Yield Landlord.

Generally speaking, REITs are famous for three things:

  • They pay high dividends.
  • They are defensive investments.
  • They tend to outperform in the long run:

REITs outperform all other sectors

It is then not a surprise that an estimated 80 million Americans invest in REITs through their retirement savings and other investment funds.

When you combine "lower risk" with "higher reward", you tend to get the crowd's interest and REITs have a track record of providing just that.

  • They generate stable cash flow through rents that are contractually guaranteed - often for many years to come.
  • They tend to be less volatile as the higher dividend yield acts as a shield against daily volatility.

Now, while REITs have helped to build many fortunes; they have occasionally also led to massive wealth destruction. Bankruptcies are rare in this sector, but there are several counts of REITs that keep dropping in value and missing dividend payments.

At High Yield Landlord, we call these "landmines" and investors should do everything in their power to avoid stepping on one, and this starts with education. In this article, we will study the most common reasons that have led to large losses in the REIT industry. Our aim is to learn from the past so that we know how to detect the landmines and improve performance in the future.

Landmines in the REIT sector

source

#1 Reason for Losses - Conflicted Management Team

Still, to this day, there exists a number of REITs, especially in the small-cap segment, in which the management interests are not aligned with those of the shareholders. In some of these, management teams are more worried about their own pay than the performance of the underlying stock.

If this is the case of your REIT, you are unlikely to see strong returns even if everything else looks perfect on the surface. A misaligned management team will always find a way to steal from shareholders if that is its objective.

We have seen this quite a lot with REITs that are "externally-managed"; especially when the managers have little skin in the game other than their salary. Then, these managers will not hesitate to issue more and more shares, regardless of its price, in order to grow the portfolio to justify higher fees.

REIT conflicts of interest

Source

This practice is perhaps the number #1 reason behind losses in the REIT sector. On one hand, shareholders get diluted, but on the other, the managers get a pay raise through higher fees. It is literally taking money from one pocket (shareholder) and putting it in the other (manager). It should be illegal but many get away with it.

This practice is relatively rare in the highly scrutinized world of large caps, but 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: Senior Housing Properties (SNH), Hospitality Properties Trust (HPT), Industrial Logistics Properties (ILPT), and Office Properties Income (OPI) to name a few.

#2 Reason for Losses - Overleverage in Late Cycle

Charlie Munger likes to say that:

There is only three ways a smart person can go broke: liquor, ladies, and leverage."

Now the truth is - the first two he just added because they started with L - it's leverage.

In good times, leveraging a property investment can result in spectacular results. If you buy an 8% yielding property and finance it with 80% debt at a 4% interest rates, you may earn a 24% cash-on-cash annual return without even accounting for growth and appreciation.

However, once the cycle reverses, you then get crushed as losses are also amplified. There are no benefits to making a killing for a few years just to go broke thereafter once the cycle reverses. Trump is a good example of a property investor who has made but also lost billions due to overleverage. The same applies to REITs.

REIT bankruptcies

Source

Most REITs learned their lesson in 2008 and now follow a very prudent approach with leverage. This is not, however, the case of every REIT, and there are quite a few of them that are taking extreme risks today as we enter the 11th year to this already extended cycle.

There is nothing like leverage to destroy wealth in a downturn, so be prudent to not pick overleveraged REITs.

#3 Reason for Losses - New REIT IPOs and Spin-Offs

Freshly IPOed stocks have historically been poor performers. The seller generally waits for the best time to get the highest price and more often than not they may have a good reason to want to cash out. With REITs, we have found that this is especially true if the REIT was created as a result of a "Spin-off" from another entity.

Here are three recent examples that have been greatly discussed on Seeking Alpha: (1) Uniti Group (UNIT), (2) Washington Prime (WPG), and (3) New Senior (SNR).

REIT IPOs underperform

In each case, the newly created REIT was sold off from another entity. Call me crazy, but the chart leads me to think that maybe they knew something and wanted to get out while they still could! When investing in IPOs or spin-offs, always question the interests of the seller.

#4 Reason for Losses - Overvaluation

If you overpay for a REIT, even if it is a great one, your investment prospects are likely to be disappointing. There exists plenty of REITs that trade at massive premiums to NAV today. Here are the Top 10:

REITs and the highest premiums to NAV

Source

When you buy a REIT that trades at a large premium to NAV, you are diluting your real estate investment by receiving less exposure to underlying properties.

On one hand, this premium to NAV may lead to superior growth (access to cheap capital); but on the other hand, if the company disappoints in any way, it could quickly lead to sharp losses.

When you command a 100% premium to NAV, you have much more to lose than when you trade at a reasonable 20% discount to NAV. One is valued based on highly optimistic projections, whereas the other one only has to achieve minimal targets to satisfy the market.

We are reluctant to pay more than a 20% premium to NAV - regardless of what the REIT does. We much rather buy below estimated NAV and not rely too heavily on growth prospects that may not materialize.

#5 Reason for Losses - Technology and Property Obsolescence

When you invest in REITs, you should always keep in mind that you are buying real estate, and while one property may produce very consistent cash flow and grow in value, another one may become obsolete and turn dark. In today's highly digitized world, technology is having an enormous impact on the performance of different property sectors.

Dead malls and REITs

Source

The most obvious example here is CBL (CBL) with its Class B Mall portfolio. With the growth of Amazon (AMZN), the department stores retailers Sears (OTCPK:SHLDQ), Macy's (M), and J. C. Penney (JCP) have had to close down a lot of stores and lower quality mall landlords have had troubles to maintain NOI in check.

Similarly, in the hotel sector, Airbnb (AIRB) poses a big threat, and in the office sector, WeWork (VWORK) is stealing market share from traditional office landlords.

Technology can crush investment results in real estate if you do not anticipate the trends and adapt to them early on.

Our REIT Portfolio Analytics:

High Yield Landlord

Source: High Yield Landlord Real Money Portfolio

At High Yield Landlord, our REIT Portfolio is designed to avoid landmines:

  • (1) Management issues: We do not invest in externally managed companies with no skin in the game and clearly conflicted interests.
  • (2) Overleverage: We keep our average Property LTV ratio below 40% to avoid overleveraged REITs in this late-cycle economy.
  • (3) IPO Busts: We skip the REIT IPOs in the great majority of cases to remove this risk altogether.
  • (4) Overvaluation: We mitigate the risk of overvaluation by targeting REITs trading at deep discounts to NAV, low FFO multiples, and high dividend yields.
  • (5) Property Obsolescence: Finally, we focus on sectors that are more resilient to technological shifts, including specialty real assets, net lease, residential, and storage:

High Yield Landlord

Source: High Yield Landlord Real Money Portfolio

With a mere $65,000 allocated across 19 holdings, we are able to generate a dividend yield of ~7.7%, translating into the average monthly passive income of ~$420, with at least $250 coming in every month. Assuming, we manage to avoid the landmines, we expect this income to grow through a lucrative combination of dividend per share growth as well as reinvested dividends, creating a snowball effect.

Closing Notes: REITs Can Be Wonderful… If You Pick The Right Ones…

REITs can be truly wonderful, but you need to know what you are doing. Unfortunately, the average investor keeps stepping on landmines and suffers from very poor performance:

To demonstrate this, consider that the average investor generated only 2.6% per year over the past 20 years. Contrast that to what more knowledgeable investors in the REIT space have achieved to do. The largest REIT research firm has a track record of 22% per year by being selective and only investing in underpriced REITs while avoiding the overpriced ones:

Source

Disclosure: I am/we are long CBL.PE. 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.