How To Spot A Dangerous REIT Investment

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Includes: AIRB, CBL, GNL, IIPR, JCP, M, O, OPI, SHLDQ, SIR, SNR, SPY, UNIT, VWORK, WHLR, WPG
by: Jussi Askola
Summary

REITs are famous for their long track record of market-beating returns.

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

We present how we avoid stepping on landmines at High Yield Landlord.

Currently more than 80 million Americans invest in REITs directly or through REIT mutual funds or exchange-traded funds (ETFs). This is not surprising when you know that the easiest way to outperform markets in the past 30 years would have been to overweight REITs in your portfolio.

REITs have consistently generated greater total returns and paid higher dividends, all while being less risky than most other stocks:

REITs outperform stocks and bonds Source

Counting out the last 3-year period, the return differential is even more important:

REITs beat stocks

Source

From 1997 to 2016, REITs generated up to 4x higher total returns than the S&P 500 (SPY).

Now, while that's all great, it is important to recognize that it is not all sunshine and rainbows in REITville. Many investors have found out the hard way that REITs can be particularly punishing to investors who lack research resources and/or expertise to conduct proper due diligence.

The return disparities from one REIT to the next can be massive. Consider the following example:

  • While Innovative Industrial Properties (IIPR) saw its share price rise by over 500%...
  • Wheeler Real Estate (WHLR) dropped by nearly 90%!

Innovative industrial properties cannabis REIT

Both are REITs. One destroyed massive wealth while the other created millions. How do you spot the “Dangerous REIT” before it is too late?

At High Yield Landlord, we call these "landmines" and investors should do everything in their power to avoid stepping on them, 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 avoid dangerous REITs and improve performance in the future.

Dangerous REITs to avoid

source

#1 Danger Sign – Excessive Leverage

Dangerous REITs to avoid

Ask a real estate investor how he lost his wealth, and most likely he will tell you that he took on too much debt and ended up in foreclosure. Trump is a good example of just that: he has made billions but also nearly gone broke due to overleverage. The same applies to REITs.

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

It is, however, a double-edged sword, and once the cycle reverses, you can very quickly lose it all. All it takes is a 20% drop in property prices, and your entire equity is wiped out with an 80% debt ratio. There are no upsides in making a killing for a few years just to go broke thereafter once the cycle reverses:

REIT losses

Source

Most REITs learned their lesson in 2008 and now employ leverage very prudently. This is not, however, the case of every REIT, and many of them are still taking extreme risks as we enter the 11th year to this already extended cycle.

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

#2 Danger Sign – Secular Shifts

When you buy REITs, you should always remember that they are investing in real estate.

And the performance of real estate can greatly vary from one property type to another, and one location to the next. As an example, the demand for industrial real estate is booming today due to the growth of Amazon (AMZN) like companies. At the same time, a lot of formerly popular shopping destinations are turning dark:

Source

The best example here is CBL (CBL) with its Class B Mall portfolio. With the growth of e-commerce, 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.

The real estate market is ever evolving, and if you do not anticipate the trends, you could very well end up owning what is left from the above property.

#3 Danger Sign – Overpaying for Real Estate

If you overpay for a property, you are likely to lose money down the line. It is not any different for REITs.

When you buy a REIT that trades at a large premium to underlying value of the properties, you are diluting your real estate investment by receiving less exposure. There exists plenty of REITs that trade at massive premiums today. Here are the Top 10:

Source

As an example, investors are today paying up to a 40% premium to own the net lease properties of Realty Income (O). For every dollar invested, you get less exposure, but the risks remain the same.

When a REIT trades at a high premium like that, it has much more to lose because it is valued based on highly optimistic projections. One misstep and the premium comes crashing down.

Real estate investors often say that:

Money is made when you buy

This is no different for REITs.

#4 Danger Sign – REIT Spin-Offs

Occasionally, a REIT will decide to split into two entities and unload a portion of its portfolio in the newly formed entity.

There are many reasons to a spin-off that are perfectly rational. Perhaps, the REIT wants to refocus on one specific property sector… or they are getting too large… or the market fails to correctly price the entire portfolio...

However, you should always question the motivations of the management team. More often than not, we have found that the management team probably knows something that you don’t. If these assets are so desirable, why would they want to sell them?

Here are three recent examples of REIT spin-offs that turned ugly:

  1. Uniti Group (UNIT)
  2. Washington Prime (WPG)
  3. New Senior (SNR)

In each case, the newly created REIT was sold off from another existing REIT. Call me crazy, but the chart leads me to think that maybe the management teams knew something and wanted to get out while they still could.

#5 Danger Sign – External Management

The REIT industry has come a long way. Back in the 70s, it was very common 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 that keep acting in their management's self-interest. They are more worried about their own pay than the performance of the underlying stock. Fortunately, these are quite easy to spot:

Commonly they will be externally managed. They will do regular share issuances despite the deep value of their shares. Their fees/salaries will be directly tied to the assets under management (AUM).

Externally managed REITs

Source

This leads to what we like to call “empire building”. The management team will seek to maximize the “size” of the portfolio rather than its “performance” because the management fees are directly tied to the size of the asset base. In the worst cases, the management teams will go as far as to issue new shares at discounts to NAV to buy more properties – directly destroying shareholder value along the way. Examples of REITs that have fallen victim to this behavior include Global Net Lease (GNL), Office Properties Income (OPI), Select Income (SIR), and many others.

A Conservative REIT Portfolio Designed to Outperform

There is a lot of talk about “how to identify the next big winner” on Seeking Alpha, but investors often forget that if they just managed to avoid the poor performers, they would already be well ahead of the passive indexes.

No one is immune to losses, but by ruling out the bottom 20% riskiest REITs, we have managed to avoid numerous losers.

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

  1. Conservatively Capitalized REITs
  2. Focus on Superior Property Sectors
  3. Underpay rather than Overpay
  4. No Spin Offs or Questionable IPOs
  5. Well-managed REITs with high Insider Ownership

It results in more consistent and predictable performance with lower volatility and safer dividends. We recognize that alpha is earned just as much by mitigating risks as by seeking to boost returns.

Today, we believe to have designed an optional portfolio that is capable to achieve superior risk-adjusted returns:

  • Greater Dividend Yield: 7.5% on average.
  • Deeper Value and Upside Potential: 9.5x FFO on average.
  • Low Payout Ratio: 73% on average.
  • Defensive Sectors: sizable overweight in storage, net lease, residential and specialty properties. Source: High Yield Landlord Real Money Portfolio

Source: High Yield Landlord Real Money Portfolio

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. The largest REIT research firm has a track record of 22% per year by being selective and only investing in solid REITs while avoiding the dangerous ones:

Source

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.