Why You Will Fail As A REIT Investor

Summary

• REITs have averaged 14% per year during the past 20 years. Yet, most individual investors probably didn't earn half of that.
• We discuss some of the most common mistakes that lead to disappointing returns when investing in REITs.
• Some ideas of good opportunities and other REITs to avoid today.
• Looking for a portfolio of ideas like this one? Members of High Yield Landlord get exclusive access to our model portfolio. Get started today »

REITs have been enormously lucrative investments over the past decades. They returned up to 14% per year and crushed all other sectors:

$100,000 invested at 14% per year for 20 years is worth $1.37 million today: a 13 times on your initial investment.

It's then no wonder that REITs are so popular. Unfortunately, all of this is nothing more than a mirage for most individual investors. I know many professional REIT investors that did even better than 14% per year, but I don’t know a single individual investor who has managed to earn 14% per year during the past 20 years.

They fail to earn these returns because they make repetitive mistakes that end up costing them a lot in the long run.

It has been over 10 years since I started on my journey as a REIT investor. I have seen and experienced many of these mistakes. I have lost money in the process, but most importantly, I have learnt from it.

In today’s article, I discuss the five most common reasons why investors fail when investing in REITs.

Mistake #1: Trader Mentality

REITs represent diversified portfolios of income-producing properties. They earn rent checks, month after month, and their fundamentals are fairly steady and predictable.

Therefore, most property owners are long-term oriented, focus on the income, and wait patiently for appreciation. They let their investments compound for many years, possibly decades to come and reap the compounded returns.

REIT investors are very different, but for the worse. They are impatient, short-term oriented, and quick to jump ship. This trader mentality causes them to focus on quarterly results and market volatility. They want excitement and action. And to their own detriment, they fixate on daily price quotes and trade way too much.

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When you find a good REIT at an attractive price, you should hold on to it for many years to come. This is how you earn good returns. You let the investment compound, tax free, with no interruption or transaction cost.

When you buy-sell-buy-sell, you increase the odds of making a mistake in the process, lose in compounding effect, and pay transaction costs.

Nothing costs more to REIT investors than this “trader mentality.” This is why we aim to invest like “landlords” and named our REIT advisory service High Yield Landlord.

We buy REITs as we would buy rental properties. We try to get a good deal at the purchase. Earn high income from rents. And then wait patiently for appreciation. This seemingly small difference in mindset can result in drastically different results.

Mistake #2: Popularity Contest

Investors will often buy REITs simply based on their “perceived attractiveness” and forget to ask what price they are paying.

Example:

REIT A may own very fancy office buildings with rapidly-growing cash flow. It makes for a great story and a nice investor presentation.

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On the other hand, REIT B may own old and rusty warehouses in secondary locations. It does not look great on the surface. In fact, it may even look dangerous and unsustainable.

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And yet, REIT B could very well be a far superior investment than REIT A if it's priced at a more reasonable valuation.

"For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments." Warren Buffett

We see this particularly often on Seeking Alpha. There's a specific type of REIT that gets most of the coverage: Large cap, mainstream REITs that are well known in the investment community. This includes companies like Realty Income (O), Ventas (VTR) and Digital Realty (DLR).

On the other hand, smaller and lesser- known REITs do not get much coverage at all. Unfortunately, this is exactly where the best opportunities are found. Well-known and popular companies are followed by 100s of analysts and mispricings are rare. However, smaller and lesser known REITs will often widely deviate from fair value.

The best example that comes to my mind is the case of Sprit Realty Capital (SRC) vs. Realty Income (O).

SRC is a smaller, lesser-known net lease REIT that sold off in May of 2017. The market hated it, and despite being very similar to Realty Income, it was valued at a 2x lower valuation multiple.

Realty Income was much more popular back then. Here are the results:

Don’t try to win a popularity contest. Money has no feelings. Pick the most opportunistic REIT based on fundamentals and valuation. This is not a popularity contest.

Mistake #3: Taking the Bait

REIT investors want income. And the greed for high income can often haunt investors.

There are plenty of REITs that pay close to 10% dividend yields. A few of them may be great opportunities, but many are poorly managed, overleveraged, or simply own risky properties. Taking the bait and hoping for the best is not a sustainable strategy.

Dividends are quickly cut and investors are then punished with capital losses.

There's nothing wrong with investing in higher-yielding REITs. In fact, we target an average 8% yield. However, the higher yield should not come at the sacrifice of quality.

Most high-yielding REITs are similar to Global Net Lease (GNL): Externally managed, significant conflicts of interest, regular equity dilution, not-covered dividend, and limited growth to get out of the hole. The dividend yield has been ~10% for many years, yet, its performance has been very disappointing with a steadily dropping share price:

On the other hand, EPR Properties (EPR) yields nearly 8%, but in this case, the high yield is simply the result of undervaluation. The REIT is well managed, owns great properties, has a solid balance sheet, and good growth prospects. Historically it has done very well and massively outperformed the market:

The lesson here is that if you are going to “take the bait” and invest in high-yielding REITs, you need to be very selective to avoid stepping on a landmine.

Mistake #4: Believing in Promises

I have had REIT CEOs tell me on the phone that they do not expect to issue more equity, just to a few weeks later do it anyways and cause enormous dilution to shareholders.

I won’t name specific CEOs here, but the point is that you cannot just take their word for it. A lot of REITs do their best to portray a good shareholder-orientation to the investment public, but then at the first opportunity, they stab you in the back.

You should not assume that every REIT is well managed. In fact, many of them exist for one purpose only: To enrich their management teams.

Over the years, we have learned that most externally-managed REITs cannot be trusted and should be avoided. The main issue is that the more equity they raise, the more fees they earn. Therefore, they are often more motivated to grow the portfolio than to earn high returns for shareholders.

Mistake #5: Selling Too Soon

Finally, when you get the idea of selling your REIT to lock a gain, think again. I have consistently sold too soon and missed out on performance as a result of it.

Winners often remain winners for longer than expected. Our valuation assumptions have often been too conservative and caused us to miss out on further gains.

You also should understand that it's normal for REITs to appreciate. Just because you have a large gain on a REIT does not mean that it's now expensive. If the share price performance is matched with fundamental performance, then the value remains intact.

A great example of that is Medical Properties Trust (MPW). Despite appreciating a lot since presenting our initial buy thesis, it remains a great value today:

In just three years, the company has returned more than 100% to shareholders. Yet, the opportunity remains to this day. The cash flow has grown a lot, the balance sheet has improved, the growth story has only accelerated, and the portfolio is more diversified than ever before.

Therefore, the increased valuation is justified, and even at just 13x FFO, it remains a steal. Selling now would be a big mistake in our opinion.

If you are considering to sell your REIT, often the best is to just go for a walk and think again.

Bottom Line

I still make many of these mistakes to this day. I'm not perfect, but I have learned many valuable lessons that have allowed me to outperform the REIT market averages.

Since moving all my real estate investments to Interactive Brokers, I have averaged ~16% per year. In comparison, the relevant REIT index (RMZ) returned 16.35%, which averages out to ~5% per year.

Note that this is a screenshot from my brokerage account at Interactive Brokers. The blue line represents my account since inception. The green line represents the most commonly followed REIT index.

In other words, my “landlord” approach to REIT investing generated more than 3x greater total returns for this account.

Most importantly, I earn a high yield of 8% per year which really gives me the feeling of being a real estate investor. I get paid to wait. And my strict selection criteria allow me to avoid most pitfalls of REIT investors.

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