What I Wish I Knew Before Buying REITs

Summary

• I have made a lot of money investing in REITs.
• But I have also had to learn some lessons the hard way.
• Here are 5 things that I wish I knew before investing in REITs.
• High Yield Landlord members get exclusive access to our real-world portfolio. See all our investments here »

hernan4429

I have been investing in real estate investment trusts, or REITs, for over 10 years now, and I have made many mistakes along the way.

Some of those mistakes were very costly and could have been avoided had I taken the time to educate myself before I got started.

Today, I will give you the chance to learn from my costly lessons. Here are 5 things that I wish I knew before I got started:

Lesson #1: Nothing Matters More Than The Management

Early on, I invested in a few externally managed REITs that were priced at exceptionally low valuations and very high dividend yields. One of them was Global Net Lease (GNL), which offered a 10%+ dividend yield.

I, of course, understood that the external management structure was a source of conflicts of interest and that it would likely lead to higher management costs over time. However, I thought that this was more than priced in with the REIT trading at a 2x lower valuation and a 3x higher dividend yield than some of its peers like Agree Realty (ADC).

I thought that the discount was excessive and that GNL would likely outperform over time due to its lower valuation, higher yield, and potential upside as its multiple expands closer to that of ADC.

But I quickly realized that I was wrong. GNL kept selling shares to buy more properties and since its equity was discounted, it was causing its funds from operations, or FFO, per share to decline. The management was doing it anyway, likely because a larger portfolio would justify higher fees for themselves.

Therefore, the low valuation and high dividend yield did not matter because the management was busy diluting shareholders.

Here are the results versus Agree Realty over the years:

Data by YCharts

GNL was always a lot cheaper and still is, but that wasn’t enough to make up for the poor management.

The lesson here is that no valuation is cheap enough if the management is going to do stupid things like raise equity at dilutive prices.

Paying a much higher multiple for a REIT that’s well-managed is worth it.

Lesson #2: The Dividend is Just a Capital Allocation Decision

A lot of REIT investors will select their investments based on the dividend yield and think that a higher yield will likely lead to higher total returns.

But in reality, it is often the opposite.

More often than not, the lowest-yielding REITs have actually outperformed the highest-yielding REITs over the long run.

That’s because the dividend is really just a capital allocation decision for the REIT, and it says nothing about the valuation or the future prospects of the REIT.

The yield may be high simply because the REIT has a high payout, lots of leverage, and owns risky high cap rate properties.

On the flip side, a REIT may have a very low dividend yield because it focuses on high-growth assets and retains most of its cash flows. SBA Communications (SBAC) is a great example of that with its low 2% dividend yield, but very high total returns since going public:

Data by YCharts

So the lesson here is that you shouldn’t pick your REITs based on their dividend yield.

The dividend yield should really just be an afterthought. REITs are not income investments. They are total return vehicles.

Lesson #3: Lower Leverage = Higher Returns

It may seem counterintuitive, but REITs with conservative balance sheets have enjoyed higher returns over the long run.

You would think that higher leverage would result in higher returns. After all, what’s the point of taking more risk if you are not getting compensated accordingly?

But history has shown that conservatively financed REITs outperform over the long run because:

• They don’t lose as much when the cycle turns and avoid disastrous scenarios that could destroy years or even decades of value creation.

• They can play offense when others face distress, picking up a lot of value from others.

So they may underperform a bit during the good years, but they end up outperforming over the full cycle.

Higher returns… with lower risk… Sign me up!

Lesson #4: Capex is Often Under-appreciated

Real estate needs to be maintained to remain desirable over the long run.

That’s capex… and it can be costly and vary over time.

Most REIT investors tend to ignore or underappreciate the impact of capex because they may think that it has already been deducted from FFO, a commonly used metric to estimate the cash flow. But that is not the case. In reality, FFO often overstates the true cash flow because it does not consider capex.

Therefore, it is important to adjust for that and evaluate REITs based on their AFFO instead.

Moreover, you should remember that capex can change drastically over time depending on the age of the properties, the length of the lease, and the market conditions. To give you an example: many office REITs have been protected by long leases so far, but as those leases expire, they will likely face rapidly growing capex needs as their tenants vacate space and/or demand improvements to sign a new lease. With office vacancies at a 20-year-high, it is the tenants that are in control, and it won’t be cheap for landlords as most companies move to a hybrid work setting.

Lesson #5: International REIT Markets Have a Lot of Offer

Most new REIT investors focus only on US REITs and that’s simply because there is far more research freely available on them online.

But speaking from experience, I can tell you that many of my most successful REIT investments have been foreign companies.

Often, foreign markets are 10–20 years behind, they are far less competitive, and the return prospects also reflect that.

So don’t skip foreign REIT markets just because they demand a bit more effort. Spending a bit of money to gain good research on these opportunities can be a great investment.

Closing Note

There are, of course, many more lessons that you need to learn, but this is a great start.

Remember that this is a vast and versatile sector with some great, but also some terrible companies. You need to be very selective if you want to get the most out of your REIT investments.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of ADC; SBAC either through stock ownership, options, or other derivatives. 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.