Seeking Alpha

REITs: The 4 Investment Rules You Should Know

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Includes: CBL, EPRT, FPI, ILPT, MAC, MPW, O, OPI, PLD, PSA, RMR, SMTA, SNH, SRC, SVC, VNQ, WHLR, WPC
by: Jussi Askola
Summary

REITs are perhaps the most popular investment vehicles on Seeking Alpha.

Readers have learnt that while there is a lot to like in REITs, they can also be very punishing to investors who skip their homework.

We present a simple 4-step framework to assessing new REIT investment opportunities.

Finally, we present one of our Top Picks among more conservative REITs for 2019.

REITs investments are some of the most popular on Seeking Alpha. They are my favorite asset class because they essentially combine the positive attributes of real estate investments with the benefits of a stock:

(1) Professional management: All the unpleasant work of dealing with tenants, toilets, and trash is managed by professionals with large economies of scale. These are people who do this full time, have great resources, and are likely to do a better job than you.

(2) Liquidity and low transaction cost: Unlike real estate which is highly illiquid and involves up to 10% in transaction costs on day 1, REITs are publicly listed, and shares can be traded in one click of mouse at minimal cost.

(3) Diversification: When you invest in a REIT, you own an interest in a portfolio of 10s or 100s of properties. As such, your risks are well mitigated as compared to owning one or two rentals.

(4) Passive Income: REITs must, by law, pay out 90% of their net income in dividends to shareholders. In this sense, without putting in any work, you will be earning very consistent income from a passive investment.

(5) Better long-term returns: Research shows that REITs (VNQ) outperform private real estate by up to ~4% per year in the long run, thanks to scale advantages, cost efficiencies, better management practices, and higher cash flow growth. REITs have also actually outperformed almost all other asset classes over the past 20 years:

source

Now, while that's all great, it's not all sunshine and rainbows in REITville.

Many investors have had to find out the hard way that REITs can also be particularly punishing to investors who lack research resources and/or expertise to conduct proper due diligence.

The return disparities from one REIT to another can be massive. Consider the following comparisons between 3 winners (O; PLD; PSA) and 3 losers (WHLR; OPI; FPI):

If you had invested in Office Properties (NASDAQ:OPI), Wheeler (NASDAQ:WHLR) and Farmland Partners (NYSE:FPI) you would have lost a fortune. Whereas if you had invested into Prologis (NYSE:PLD), Realty Income (NYSE:O) and Public Storage (NYSE:PSA), you would have made a killing.

It demonstrates that you need to be very selective in the REIT sector if you want to succeed. Our proprietary selection process at High Yield Landlord is not bullet-proof, but it has allowed us to pick many past winners including Essential Properties (EPRT), Medical Properties (MPW) and W.P Carey (WPC). Today, we reject 10 investments on average for every one investment that we make:

In today’s article, we let you take a peek into our selection process and how we aim to maximize chances of picking “winning REIT” for our investors.

We attempt to summarize it into a concise 4 step-process – before discussing one REIT opportunity at the end of this article.

Step 1: Always Start With The Management

If a REIT lacks management alignment, the rest of the story is meaningless. Even if a REIT appears to present great value, the management will always find a way to destroy more of it to earn higher fees if that is its goal.

Therefore, the very first step should always be to have a good look at the management and its alignment of interest. The management structure and the insider ownership are the two most relevant criteria to research here.

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. 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.

This has allowed us to avoid numerous serial underperformers such as the RMR (RMR) managed entities Senior Housing Properties (SNH), Hospitality Properties (HPT), Industrial Logistics (ILPT) and Office Properties Income (OPI) that cannot be trusted.

In fact, HPT appeared to be a good opportunity earlier this year, and yet, now it got even cheaper after the management decided to acquire a low-quality retail portfolio off Spirit MTA (SMTA). How does this make sense for a Hotel REIT? Value destruction is a real thing if the management team is not aligned with shareholders.

Step 2: Same Store NOI Growth – Why it Matters

Once you have passed step 1 and feel comfortable with the management, you should assess the quality of the assets.

Here nothing beats “Same Store NOI Growth” to quickly measure how well the assets are performing.

NOI represents the property level “net operating income”. It takes into account the rent level, occupancy rate, and all property associated expenses. “Same Store” measures the organic growth of the properties – and not the aggregate growth which could be boosted by new property acquisition.

Therefore, “Same Store NOI growth” is perhaps the best pound-for-pound measure to assess property quality. If property A is able to consistently grow SS NOI at a fast past, then it is likely to be a highly desirable asset located in a superior market.

It is a great measure to identify high quality portfolios in the REIT sector. As an example, Macerich (MAC) is a mall REIT that may screens as a “value REIT” due its low valuation multiple, but the SS NOI metric tells a different story. MAC has a track record of growing same store NOI by a hefty 4.1% per year since 2015 and this growth rate is only expected to accelerate because the sales per square foot have grown even faster. It speaks very highly for the quality of its assets.

On the opposite side of the spectrum, CBL (CBL) is having significant issues with to maintain SS NOI which has been on a free fall since the same date. Diving a bit deeper into the properties and their locations, it is clear that MAC is an urban Class A mall REIT – whereas CBL is a Class B mall REIT with much poorer locations.

The SS NOI metric captured this piece of information very well:

Step 3: The Right Balance Sheet For The Right Asset Base

Even the safest property can become extremely risky if you finance it with too much leverage. When assessing the balance sheet, it is very important to not just look at the debt level – but also to compare it to the asset quality.

This is because a REIT that owns high quality properties trading at 5% cap rates may bear much more leverage than a company with properties in the riskier 8-10% cap range. We find that EBITDA-based leverage metrics do a poor job because they do not take asset quality into account.

The higher quality REITs (which owns lower cap rate properties) will consistently have higher leverage metrics – despite often being less risky.

For this reason, we prefer to use Asset-based leverage metrics. Our favorite is the “Loan-to-value” which represents an estimate of the leverage relative to the gross market value of the properties. This metric also happens to be the most commonly used by private equity real estate investors.

Step 4: Time to Verify If it is a Bargain or Not

Finally, never forget to ask what price you are paying. Even the highest quality REIT can turn into a disappointing investment if you overpay.

We avoid overpaying for REITs by paying close attention to NAV. Many large caps such as Realty Income (O) trade at up to a 50% premium to NAV, and we expect such lofty valuations to result in disappointing long-term results. We follow a value approach and seek to buy at share prices that are deeply below estimated NAV.

Secondly, we recognize that real estate is an income-driven investment first. We are not happy with the 3-4% dividend yield of indexes and target a sustainable 7-8% dividend yield to generate high income while we wait for appreciation.

As such, our Core Portfolio trades today on average at an estimated 20% discount to NAV and pays a 7.2% dividend yield that is easily covered at a 68% payout ratio.

Source: High Yield Landlord Real-Money Portfolio

The Sweet Spot of Active REIT Investing - One Top Pick

In active REIT investing, you do not want to pay full price, but you should not be too cheap either.

Over time, we have found that our sweet spot is in quality companies undergoing temporary challenges that are solvable over time. They are not the cheapest in their peer group, but they are discounted relative to the average and provide good alpha-generation potential as they solve the issues and reprice closer to peers.

Spirit Realty Capital (SRC) was a great example of that as we invested in the company after the crash in May of 2017:

  1. It had a quality portfolio with a solid balance sheet.
  2. However a minor portion of its assets was causing issues.
  3. These assets lead to deeply discounted valuation, but they could be sold to improve market sentiment.

Since presenting our thesis, SRC has returned 77% in just two years – close to 4x more than the REIT indexes (VNQ):

It is by targeting this type of situations that we aim to outperform market averages. SRC was our largest position then and remains a sizable holding to this day at High Yield Landlord.

We expect it to keep outperforming because of three simple reasons:

  1. Deep Discount to Peers: The company is nearly identical to Realty Income (O) – the gold standard of net lease REITs – but trades at a 35% discount.
  2. Clear Catalyst: The discount is the result of an external management agreement that will soon be terminated. Otherwise, the portfolio is predominantly low-risk net lease properties with +10-year leases and automatic rent increases.
  3. Strong Total Return Proposal: Without any FFO multiple expansion, SRC is in a good place to generate close to double digit returns with a 5.5% dividend yield and 3-4% annual growth. However, Once the external agreement is finally terminated, we expect SRC to close its valuation gap to peers – leading to another 20-30% of price appreciation.

Closing Notes: REITs Are Wonderful (If You Pick The Right Ones…)

Consider that the average investor generated a tiny 2.6% annual returns over the past 20 years according to a study performed by JPMorgan:

In comparison, the best active REIT investors managed to return 22% per year on their BUY recommendations:

source

The REIT market can be notoriously rewarding but also very unforgiving to investors who pick the wrong company.

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Disclosure: I am/we are long MAC; SRC; MPW. 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.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.