What Every New REIT Investor Needs To Know

Summary

• Every new investor makes mistakes. Unfortunately, with REITs, these mistakes are often particularly expensive.
• Today, I allow you to learn some of my most valuable lessons from 10 years investing in REITs.
• Most importantly, you should focus on management quality and target defensive, equity REITs in today's late cycle economy.
• I do much more than just articles at High Yield Landlord: Members get access to model portfolios, regular updates, a chat room, and more. Get started today »

REITs are some of American’s favorite investments. In fact, they are so popular that more than 87 million Americans invest in REITs. This is really no wonder when you consider that:

• REITs have generated 14% annual returns over the past 20 years – compared to “just” 8% for the S&P 500 (SPY).
• REITs pay 2-3x more income than regular stocks.
• And they offer valuable diversification benefits to a portfolio.

Unfortunately, new investors often underestimate the difficulty of investing in REITs and end up making poor investment decisions.

The business model itself is rather simple to understand. REITs own properties. These properties generate rents that are paid by tenants. And these rents are then passed to the shareholders in the form of dividends.

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However, what complicates this seemingly simple business plan is the fact that REITs own $100s of millions, if not billions, worth of properties - ranging from apartment communities to malls, office buildings, warehouses, and anything else imaginable. Moreover, balance sheets vary greatly from one REIT to the next and management teams are often poorly aligned with shareholders.

I have been investing in REITs for more than 10 years. Early on, I made many mistakes, which could have been avoided with better education. Today, I allow you to learn from my mistakes so that you don't have to reproduce them in the future.

Management Quality is No. 1

There are a lot of seemingly discounted REITs out there that pay high dividend yields and offer enormous upside, according to some observers.

Some of them may be good opportunities, but most often, the discounted valuation is the result of poor management alignment.

And believe me when I say that it's never a good trade off to get high yield in exchange of poor management. Earning a big yield is irrelevant if it comes at the cost of a dropping share price.

Most of these high-yielding REITs rarely rise up to the occasion and end up severely underperforming the other “more expensive” REITs in the long run. Just take a look at the RMR-managed (RMR) REITs: Office Properties (OPI), Diversified Healthcare Trust (DHC), Service Properties Trust (SVC) and Industrial Logistics Properties (ILPT).

Data by YCharts

Despite paying high yields, they have all performed very poorly. They each own different property types, but all share one common thing: The same management.

Time and time again, this management has cut dividends, diluted share holders and changed the name of their REITs in an attempt to hide previous missteps.

You should avoid such REITs at all cost because if the management is poorly aligned, it will always find a way to destroy returns.

How do you recognize poorly-managed REITs?

There are often evident clues that can help you sort out the worthwhile from the wobbly. Try to look for the following red flags:

• External management structure: This on its own does not mean that the company is poorly managed, but it's often the first clue.
• Capital raises at dilutive price: Poorly-managed REITs will often try to maximize the size of the portfolio by raising new equity, even if its shares are priced at a low valuation and high dividend yield. This is a big red flag.
• Compensation relative to assets: Many REITs overpay their managers for average results. A good metric to look at is G&A relative to assets.
• Insider ownership: Some REIT executives have very little skin in the game other than their salaries.

Whenever a REIT has two or more of these red flags, we stay away. We favor internally-managed REITs with high insider ownership (a multiple of annual salary) and demonstrated discipline in capital allocation.

When you invest in well-managed REITs you have time on your side. Even if the yield is a few hundred basis points lower, you’ll likely do much better in the long run.

Most Mortgage REITs Are Poor Investments

The second mistake that new REIT investors often make is that they favor mortgage REITs over traditional equity REITs.

Mortgage REITs pay higher dividend yields which lures a lot of unsophisticated investors. Unfortunately, the higher yield is often not sustainable and the business model is very sensitive to changes in interest rates.

To give you an example, consider Annaly’s (NLY) track record of dividend payments. This is supposedly the “blue chip” of residential mortgage REITs, and yet, its track record is very volatile and unpredictable:

Source

Mortgage REITs are heavily leveraged and small changes in interest rates can make or break your investment.

Over the past cycle, mortgage REITs have earned 0% total returns – demonstrating the risks of the business model. Equity REITs generated near double-digit returns over the same time period:

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Now compare this to Realty Income (O), an equity REIT with a lower dividend yield but consistent growth:

Source

Realty Income is richly valued right now, and we are not buyers, but a few of its close peers remain very attractively priced. It's much better to earn a sustainable and growing 6% dividend yield than an unsustainable 10% yield. Stick to equity REITs and skip mortgage REITs, especially if you are a new REIT investor with little knowledge.

In Late Cycle, Invest in This Type of REIT

There exists roughly 200 REITs and each differ greatly in the type of assets they own, the quality of their balance sheet, and management.

Today, we are 11 years into the cycle and economic growth is decelerating. If there's anything to be learned from the great financial crisis, it's that you should favor defensive REITs in a late cycle economy.

At High Yield Landlord, we invest primarily in REITs with…

Defensive properties:

• Recession-resistant cash flow.
• Long remaining lease terms.
• Strong rent coverage.

Conservative balance sheets:

• Loan to value below 40%.
• Capacity to expand debt.
• Limited maturities in coming years.

Superior management teams:

• Internal management.
• High insider ownership.
• Track record of market-beating returns.

Organic growth prospects:

• Automatic rent increases in lease.
• Self-funded redevelopment projects.
• Below market rents.

High Dividend and Margin of Safety:

• 6-8% average dividend yield
• Conservative payout ratio
• Discounted valuation

A good example right now is EPR Properties (EPR). It has everything listed above and more. It's a lower-risk REIT with 13-year triple net leases that produce recession-resistant cash flow. The 6.5% dividend yield is well covered and growing by ~5% per year. We expect double-digit returns in the coming years.

It's by investing in these type of REITs that we aim to beat the market. New REIT investors should look for these type of quality REITs that trade at reasonable valuations.

You do not want to be left holding the junk when the cycle finally turns. At the same time, you cannot just pick blue-chip REITs, pay an expensive price, and expect good results either.

The sweet spot is in the middle: Quality companies trading at a reasonable valuation. Right now, our REIT Portfolio pays a 7.3% dividend yield that's fully covered with a conservative 69% payout ratio.

Most importantly, we achieve this superior yield by investing in high-quality companies with sustainable cash flow. Skipping poorly-managed companies, mortgage REITs, and other unattractive REITs is what has driven our outperformance over the years.

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Analyst’s Disclosure: I am/we are long EPR. 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.