You Get What You Pay For: Avoid These 2 Very Cheap REITs

Summary

• If you’re going to put your money down on something, always make sure you understand it first.
• Once you buy a stock, it’s yours. And you should prefer to own stocks that perform. Well.
• Since I preach what I practice and write what I believe, I’m just as prone to pointing out REITs that aren’t worth buying.
• I do much more than just articles at iREIT on Alpha: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »

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The saying "you get what you pay for" is either very misused or very misguided.

I guess it depends on your interpretation. But here's the common way of seeing it: If you're going to buy something that costs "cheap," you're going to get something that's made cheap.

In which case, the more expensive something is, the more worthwhile it will be.

That's certainly the interpretation behind the BBC's November 2014 article "The Myth of 'Getting What You Pay For.'" It begins with the pull quote, "Why are some investors obsessed with… paying more and getting less?"

That's to lead into this:

"When you are investing, you want to keep as much of your investment as possible - So the more you pay in fees, the less you keep.

"Nonetheless, an aura has developed around some of the highest-cost investments - hedge funds - while some of the lowest-cost options - index funds - hardly make the headlines.

"Index funds, particularly the exchange-traded variety known as ETFs, are attractive since you often pay minimal management and brokerage fees. In return, you're promised returns on pace with the market - less minor costs."

Now, unlike the BBC article, I'm not writing this to trash talk hedge funds. Though I will take a moment to plug my upcoming REIT ETF.

These vehicles can be superior investments, as mine is being designed to be.

Give and Take, Take and Give

Admittedly, if you're the hands-on type who likes to outpace the markets, I wouldn't suggest investing in ETFs.

They're designed to be very balanced, with any negatively performing stocks cancelled out by any best-performing stocks. In that, they're very much like any other portfolio.

But because they tend to invest in every single selection of a market segment, they often reap more conservative returns. Compared to an experienced, sensible portfolio filled with individually selecting assets, that is.

If you're simply trying to make the most out of the markets with as little effort as possible, however - whether from lack of confidence, lack of time, or lack of funding, any of which is understandable - ETFs can most definitely be the way to go.

Hence why I'm willing to put my name to one.

In addition, they really are a great example of why the traditional way of interpreting "you get what you pay for" isn't always accurate. To quote that article again:

"Of course, it depends. But research consistently shows that, when buying hedge funds and other forms of 'active' management such as traditional mutual funds, investors aren't always getting the performance they paid for.

"According to Hedge Fund Research data, standard stock and bond indices over the past five years have been trouncing hedge funds of all walks. In 2013, for example, the Standard & Poor's 500 Index total return, with dividends, was 32.4%. The HFRI Equity Hedge Index was less than half that, at 14.3%. (To be fair, in the pits of 2008, the S&P 500's total return was -37% and the hedge fund average was -27%).

In short, the expensive choice might be the right way to go. Or it might not be.

There's no blanket rule to guide you here.

The Two Factors Needed When Inspecting a Stock

The same goes for electronics. Or generic-brand vs. brand-name groceries. Or houses. Or cars.

That expensive example you're considering might last the test of time. Or it could let you down intensely.

That cheap example you're considering might be a bargain. Or it could be an abject waste of your hard-earned dollars.

That's why I prefer a different interpretation of "you get what you pay for" - and one I think is just as accurate, if not more so…

If you're going to put your money down on something, always make sure you understand it first.

You know I like a bargain as much as anyone, if not more so. Promising real estate investment trusts (REITs) fall out of favor sometimes for no good or lasting reason. In which case, I might very well be right there to recommend them.

But there are two key factors that have to meet before I do:

1. Notably high quality
2. Notably low price

Because once I buy a stock, it's mine. And I prefer to own stocks that perform.

Well.

For a long time.

Since I preach what I practice and write what I believe, I'm just as prone to pointing out REITs that aren't worth buying as I'm those that fit my two-part equation. This article, as the title promises, details two that come with notably low prices.

But that's where their benefits end…

One Externally Managed REIT to Avoid

Let's start with Office Properties Income Trust (OPI). It's externally managed by RMR LLC (RMR), which also manages:

• Diversified Healthcare Trust (DHC)
• Industrial Logistics Properties Trust (ILPT)
• Service Properties Trust (SVC).

RMR also provides services to other private and public companies, including Five Star Senior Living (FVE), TravelCenters of America (TA), and Sonesta International Hotels.

(Source)

In my recent 2022 REIT Resolution article, I made it clear that I avoid most externally-managed REITs. And OPI is no exception.

It has no employees whatsoever, so its ability to achieve its business objectives depends very heavily on RMR.

Filings easily show conflicts of interest, and management agreements aren't negotiated at arm's length. Plus, those agreements involve substantial penalties if terminated:

"… if we terminate a management agreement for convenience or if RMR LLC terminates a management agreement with us for good reason, as defined in such agreement, we are obligated to pay RMR LLC a termination fee in an amount equal to the sum of the present values of the monthly future fees as defined in the applicable agreement, payable to RMR LLC for the term that was remaining before such termination, which, depending on the time of termination, would be between 19 and 20 years."

And…

"Our management agreements with RMR LLC may discourage a change of control of us, including a change of control (that) might result in payment of a premium for our common shares."

RMR's base management fee is tied to OPI's share price performance: An annual fee generally equal to 50 basis points (bps) multiplied by the lower of OPIs:

1. Historical cost of real estate
2. Total market capitalization

And there's no incentive for RMR to complete any transaction that could reduce its share price.

Always read the filings folks!

OPI Continued…

The company owns 181 properties and derives around 23.5% of rental income from the Washington, D.C., market. Its enterprise value is over $3 billion, which should mean it could thrive by internalizing operations.

If not for that disadvantageous management contract.

Yet external management is just one red flag with this office REIT. We also need to look at its balance sheet.

OPI has the worst credit metrics in the office sector:

(Source: iREIT / REIT Base)

(Source: iREIT / REIT Base)

(Source: iREIT / REIT Base)

This begs the question of how safe its dividend is.

(Source: iREIT / REIT Base)

The answer isn't the best, as evidenced above. So riddle me this…

Even though OPI is throwing off an 8.9% dividend yield with a price to funds from operations (p/FFO) of 5.2x, would I buy this REIT?

The answer is easy: Absolutely not.

Just consider the equity yield of 19.3% and the weighted average cost of capital is something like 12%. Plus, it's offering -12% growth in 2021 and 0% growth according to analyst estimates for 2022.

Bottom line: Beware of this value trap!

(Source: FAST Graphs)

Another Externally Managed REIT to Avoid

I've already brought up Diversified Healthcare Trust, since it's also managed by RMR. As the name suggests, this REIT owns a diversified portfolio of properties that includes:

• Life-science tenants
• Medical office tenants
• Senior living tenants

As of Q3-21, its $8.2 billion portfolio included 392 properties in 36 states and Washington, D.C.

While reviewing its filings, you can see many of the same boilerplate risks OPI faces. The external management agreement and conflicts of interest are obvious problems once again.

However, here's another one: DHC owns over 10 million shares in Five Star Senior Living, it's largest tenant. that represents around 33% of all outstanding shares.

Why is this important? I'll quote its previously mentioned filing:

"We are party to transactions with related parties that may increase the risk of allegations of conflicts of interest, and such allegations may impair our ability to realize the benefits we expect from these transactions."

They can say that again.

So how solid is Five Star?

(Yahoo Finance)

What you see is what you get…

To be clear, DHC has been working to increase exposure in its defensive sectors - life science and medical office. The result is that they represented over 83% of its Q3-21 net operating income (NOI).

In addition, DHC has worked to transition 107 of its senior housing communities to a more diverse operator mix. As is, FVE still manages 120 of DHC's senior living communities with approximately 18,000 living units.

To RMR's credit, the management fee is now tied to DHC's share price performance, consisting of an annual fee based on 50 bps of the lower of DHC's:

1. Historical cost of real estate
2. Total market capitalization

And there's no incentive for RMR to complete any transaction that could reduce DHC's share price.

Nonetheless, DHC's fundamentals remain troubling, including when it comes to its leverage:

(Source: iREIT / REIT Base)

(Source: iREIT / REIT Base)

(Source: iREIT / REIT Base)

Its dividend history is scary too:

(Source: FAST Graphs)

You may even recall that I warned investors back in February 2019 when the company was called Senior Housing Properties:

"On an AFFO basis, the dividend is at a higher risk, over 108%, suggesting that this REIT is a 'sucker yield.'

"I don't know about you, but I don't think Mr. Market has priced in a dividend cut yet… and I would be careful jumping into that frying pan when you know that it's gonna most likely burn you."

Could DHC become a "cigar butt" pick?

Not for me…

Shares are trading at $2.63 with a dividend yield of 1.5%. And I could see that price falling further still.

In Conclusion…

Re-referencing my 2022 New Year's Resolutions, there are 10 investing goals I'm trying to live by - all of which I want to consistently model for you.

One of those rules is to avoid external management (with very few outliers). Another is to focus on high-quality blue chips, which I expect will prove especially important next year.

Finally, there's Rule #10, which is perhaps one of the most important New Year's resolutions for all readers.

It's exactly as follows:

(Source)

P.S. Here's a fundamental snapshot of RMR:

(Source: FAST Graphs)

P.P.S. Here's a fundamental look at ILPT, which I'm working on a deep dive for iREIT members:

(Source: FAST Graphs)

Happy New Year!

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.

Author's Note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: written and distributed only to assist in research while providing a forum for second-level thinking.