As investors become better educated about real estate investing, they also become better REIT investors over time. Not all real estate is created equal and the sector decision is at least as important as the security decision.
There are large differences from one property type to another, and ultimately, some are more desirable than others.
One important factor that has long been ignored (or underestimated) by REIT investors is the impact of capex on the long-term returns.
Capex is the cost to maintain a property. It may not impact the returns on Year 1, but sooner or later, you will need to reinvest in the property to keep it in good standing – otherwise, your tenants will bail out on you.
All else held equal, the lower the capex, the better it is for the investor. There's no good in earning a high rate of return, if all of it comes crashing down in Year 5 because you now need to heavily reinvest in the property to keep it rented. You would rather earn consistent and predictable returns with minimal impact from capex. We heavily overweight low-capex property investments for this reason.
Over time, researchers from Green Street Advisors (largest REIT research firm in the world) have found that low-capex properties generate higher rates of return than high-capex properties. They have outperformed in the past and they expect them to keep outperforming in the future.
It's true for private real estate, but it's true for REITs also.
REIT investors who favor low capex property types have historically earned higher rates of returns and we believe it's going to be true in the future as well. They also earned higher income with less volatility.
Therefore, it's imperative that we invest heavily in these low capex companies as we attempt to outperform the broader REIT market in the long run. Below, we provide an overview of low capex vs. high capex property types. We discuss which sectors you should overweight in your portfolio and which sectors to avoid.
Low Capex vs. High Capex Properties
The main determinants of capex are:
- The property characteristics.
- The tenant requirements.
- And the lease.
Some properties use materials that last much longer than others. Tenants also are much pickier about the design of their office headquarters than their warehouse. Finally, certain leases allocate a portion or all of the property maintenance cost to the tenant. And the longer the lease, the lesser capex you’ll suffer from.
Below is a chart ranking various property types from the highest operating margin to the lowest. It includes maintenance capex and operating expenses:
Net Lease Properties (Incl. Gaming) – Very Low Capex
Net lease properties enjoy the highest operating margins. This is because tenants pay all property expenses, including capex. Moreover, the leases are very long and vacancies are rare.
Net lease properties can be anything: Taco Bell restaurants, CVS pharmacies, hospitals, casinos, warehouses, etc…
source
The lease is the determinant factor here. It's generally very long with a 10-15 year term and it's the tenant’s responsibility to pay for everything, from fixing the leaking roof, to repairing the parking lot, and paying property taxes.
We invest heavily in these properties because the lease is more favorable to long-term oriented investors. The income is more consistent, the margins are higher, and the risk of getting hit with a large capex bill is limited.
Good examples of Net Lease REITs include Realty Income (O), STORE Capital (STOR) and W.P Carey (WPC). Most of these large caps are richly valued today, but opportunities remain abundant among smaller net lease REITs. This is where we invest at High Yield Landlord.
All in all, they make up 33% of our total portfolio - a large overweight relative to REIT benchmarks. We believe that this large allocation to net lease properties will lead to more consistent returns, higher dividend income, and long-term outperformance.
Land Investments – Low Capex
The above chart does not include land investment companies because by definition they only invest in land, which does not have any capex expense. It's the structure and the improvements that need to be maintained – not the land itself.
Today, there exists farmland REITs, timberland REITs, and other land investment REITs that generate cash flow by renting the land for various uses. They are free from capex to the most part, which is very attractive.
We currently invest in one land investment company and that's UMH Properties (UMH). UMH is generally categorized as a manufactured housing REIT, but in reality, the fundamentals are that of a land investment company because the REIT rents lots to tenants who bring their own manufactured home on site.
Therefore, the maintenance capex is limited. UMH must maintain the site and infrastructure in good condition. But the maintenance of the homes is the responsibility of the tenants for the most part. UMH only pays for the maintenance of the homes that it owns itself (7,300 rentals for a 23,000 developed lot portfolio).
Note that UMH also owns a vast portfolio of undeveloped land (25% of total acreage) that's free of any capex (potential for additional ~6,000 lots).
Specialty Properties – Mid Capex
Some specialty infrastructure has high capex. For instance, airports have fairly high capex and operating expenses because they are in very heavy use.
Other infrastructure however has much more limited capex needs. Energy pipelines are a good example of that. You lay the pipes correctly and then the maintenance cost is fairly low. There's no carpet to change or parking to repair. The pipes depreciate over time and you eventually replace them altogether. This is a real expense. However, the maintenance cost in between is limited and the operating expenses are fairly low. The same applies to communication infrastructure.
We currently own three infrastructure investments that represent nearly 20% of our Core Portfolio.
All Other Property Types – Mid to High Capex
Malls And Shopping Centers do surprisingly well. In the past years, the capex was high but this was not only maintenance capex. A big portion of it was investment capex as malls redeveloped properties to diversify uses. This higher level of capex won't last forever.
Malls are massive properties that generate significant rental income – all under one roof. The properties are quite cost efficient when you consider the enormous amount of income that they produce.
Moreover, grocery store anchored shopping centers, such as those owned by Kimco (KIM), will often (not always) structure their leases on a triple net basis - which lowers capex expense.
Industrial properties also are quite cost effective to maintain. Tenants want functional space, but the design and architecture is not as important as for an office building. Moreover, the building materials are relatively inexpensive here which makes it cost effective to repair when needed.
With residential properties, it depends. A large apartment complex that's new and well built, won’t suffer from large capex for many years, potentially a decade to come. Tenants pay deposits and if they break something they are liable for it. Eventually roofs start to leak, windows need to be replaced, and the parking needs fixing. This is true for all properties, but because apartment complexes are so large, they enjoy some economies of scale. With single family houses, you have the same issues but lack economies of scale.
Finally, office and hotel properties are arguably the worst in terms of capex. Office tenants are notoriously picky about small things such as the carpet, wallpaper, design, architecture, etc., and they are commonly given significant tenant improvements as an incentive to sign a lease. Unless you own a Class A property in a highly-desirable location, the tenant will have considerable bargaining power and take advantage of it.
Hotels are in heavy use. New guests come and go every day and do not respect the property as they would if they were living in it. You cannot screen your tenant as you would if you were renting a single-family house. Some guests are great. Others have zero respect. In the end, your maintenance cost is materially higher because of property damage but also because you need to maintain the property in top shape to keep customers happy. A stain on a wall is big deal in a hotel, but not so much in a warehouse.
We currently hold two positions which suffer from above average capex - representing just 9.23% of our portfolio.
Overweight Low Capex, But Diversify Opportunistically
If net lease REITs, manufactured housing REITs, and other low capex properties outperform over time, why not just invest it all in these REITs?
Well, it's important to remember that capex is just one piece of the equation. “All else held equal,” we prefer low capex properties – but everything else is rarely equal in reality. Fundamental strength is one thing. The price that you pay for it is just as important.
The low capex property types are commonly very expensive. Investors know that net lease REITs are very attractive, and therefore, they will commonly trade at rich valuations, which makes them less compelling.
On the flip side, the market will commonly punish higher capex REITs with a discounted valuation, and this discount may sometime become excessive – which makes them compelling investments – even despite the higher capex nature of the properties.
We overweight low capex REITs, but diversify opportunistically with higher capex properties that are offered at a deep discount to fair value. This includes our investment in Macerich (MAC) which we estimate to trade at a 50% discount to net asset value.
Bottom Line
Capex is one of the most overlooked factors – yet it's one of the most important factors in determining long-term returns.
All else held equal, we prefer low capex property sectors such as net leases, manufactured housing, industrial, grocery store anchored shopping centers, specialty infrastructure, farmland and timberland.
Whenever we can find good opportunities in these sectors, you should expect us to favor them over property types that are hit with greater capex.
We currently are eyeing new potential investments in two industrial REITs that structure their leases on a triple net basis.
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