- REITs are some of the only stocks trading at attractive valuations right now.
- But not all REITs are equally attractive. Investors have to learn to select the best ones.
- In this note we cover our three biggest red flags and problems to watch out for when investing in REITs.
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The market has largely recovered from the steep sell off that we saw in March 2020. In fact, much to most people’s surprise, we saw many equities soar to new highs relatively quickly. As a result, some investors are struggling to find companies trading at discounted valuations.
REITs are one of the few investments still trading at a reasonable value. Many have still not fully recovered from the Marsh crash, making them an attractive turnaround play. Since most these REITs pay lucrative dividends, you also get paid while you are waiting.
New investors are entering the REIT market, and for the reasons stated above, it’s easy to understand why they’re excited. That said, every sector has its bad apples, and there are a few things you want to avoid when investing in REITs. Some subsectors of the REIT market are facing significant headwinds, while other REITs have excessive leverage or poor management.
Below we discuss why these red flags matter and how to spot them.
Avoiding Risky Property Sectors
The landscape of REIT offerings is wide and varied. Within the world of REITs, there are individual subsectors ranging all the way from rural farmland to data centers.
So just because two companies are REITs doesn’t mean they’ll trade similarly. This is especially the case if we compare REITs in two very different subsectors.
For example: RLJ Lodging (RLJ) is a hotel REIT, and sold off pretty heavily during the March crash. But farmland REITs Gladstone Land (LAND) and Farmland Partners (FPI) hardly dipped at all, and then retraced to close to their original value:
Today, several REITs face headwinds that are specific to their subsector. The most challenged types of REITs right now are:
The pandemic has exacerbated recent trends that hurt these property sectors specifically. Malls are struggling as consumers turn more and more to Amazon (AMZN). People are traveling much less, punishing hotels. And offices have fallen out of favor with the strong and recent shift toward working from home.
If you still want exposure to these sectors, you can choose to invest in them, but you should own the highest-quality properties and weigh your positions in your portfolio accordingly.
We prefer to invest into subsectors of the REIT space that we consider much more stable for the long term. These are subsectors like:
- Healthcare REITs
- Net Lease REITs
- Residential REITs
Not only will healthcare properties be in demand due to the recent pandemic, they're also a good long-term bet because of the rapidly aging demographics in western countries. Net lease properties often have world class tenants, and the contract on these leases is sometimes over a decade long, making these kinds of properties quite stable. Lastly, we like the residential space because housing and shelter is an essential need that will never go away.
Avoiding Over-Leveraged Balance Sheets
The balance sheets of most REITs are today far better than they were during the 2008 crash. This is true in general, but some companies still have rates of leverage that we would consider problematic.
For example, take two industrial REITs: Plymouth Industrial (PLYM) and STAG Industrial (STAG). On the surface, these companies may seem similar. But if you examine the balance sheets, you’ll find that PLYM has 2x more leverage compared to STAG. This is why STAG held up much better during the sell off and recovered much faster:
This is why it’s important to evaluate the financials of these companies before investing. They may seem similar at first glance, but eventually excessive debt will catch up to the REIT’s performance.
So when in doubt, remember the wise words of Charlie Munger:
“There are only three ways for a smart person to lose it all: liquor, ladies, and leverage.”
At High Yield Investor, we avoid overleveraged REITs by only investing in REITs with maximum 50% loan-to-value.
Avoiding Poor Management
The final red flag new investors should be aware of is how management can vary across different REITs. If a manager’s interest is poorly aligned with the interest of shareholders, it can hinder the performance of the REIT over time.
Unfortunately, some managers are more concerned with increasing their assets under management ("AUM") fees rather than improving the performance of the REIT. This misalignment is what’s known as a conflict of interest, and it can be one of the pitfalls of externally managed REITs.
Some REITs with external management teams are those run by RMR (RMR). Office Properties Income (OPI), Diversified Healthcare Trust (DHC) and Service Properties Trust (SVC), for example, performed poorly for years already before the pandemic even began:
REITs with poor management may look like they’re trading at bargain-basement valuations, but there’s a reason for it. Over time, even if you pay a slight premium for a better run company, the excellent management you receive will be worth the extra investment.
For this reason, at High Yield Investor, we exclusively invest in REITs with internal managers that have significant skin in the game.
When In Doubt, Choose Quality
While we began this note by pointing to the bargains in the REIT sector, we also wanted you to be aware of possible value traps that exist out there.
If we look at annualized rates of return over the past two decades, we can see clearly how REITs outperform other investments:
But all of this rests on the necessity of choosing the right REITs. We can see below that the average annual return of REITs was 10.9% between 1996-2015. However, the average investor achieved a measly 2.1% annual return:
How is this possible? It’s largely due to buying the wrong companies. Even if the average investor does have REIT exposure, they don’t take the time to watch out for the red flags we discussed earlier.
Poor management, struggling subsectors, and companies over their heads in debt do exist, and wise investors must be careful of these things when choosing their REITs.
If you can choose REITs that are in resilient subsectors, with excellent management teams and strong balance sheets, you’ll be scoring some of the highest quality investments available today - all at a nice discount. Just remember to avoid the red flags discussed above.
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This article was written by
Samuel Smith is Vice President of Leonberg Capital, he has a diverse background that includes being lead analyst at several highly regarded dividend stock research firms. He is a Professional Engineer and Project Management Professional and holds a B.S. in Civil Engineering & Mathematics from the United States Military Academy at West Point and has a Masters in Engineering.Samuel runs High Yield Investor investing group. Samuel teams up with Jussi Askola and Paul R. Drake where they focus on finding the right balance between safety, growth, yield, and value. High Yield Investor offers real-money core, retirement, and international portfolios. The services also features regular trade alert, educational content, and an active chat room of like minded investors. Learn more.
Analyst’s Disclosure: I am/we are long WPC. 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.
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