I have been investing in Real Estate Investment Trusts, also known as REITs (VNQ), for well over a decade, and I have made some great but also some bad investments along the way.
Back when I started investing in REITs, there unfortunately wasn't nearly as much educational material on REITs online, and as a result, I had to learn some lessons the hard way.
Had I known these things, I would have avoided some painful losses and earned even better returns over the years.
Here are 5 important lessons that you need to know before investing in REITs.
Learn from me so you don't suffer the same losses.
Lesson #1: The Dividend Should Be An Afterthought
A lot of investors are attracted to REITs because of their high dividend yield.
I still remember buying my first REIT which offered a 10%+ dividend yield, thinking that I could earn significant passive income and high total returns.
But here you need to know that the highest-yielding REITs are often the least rewarding over the long run.
It may sound counter-intuitive, but lower-yielding REITs have actually been far more rewarding than higher-yielding REITs in most cases.
To give you an example: Global Net Lease (GNL) is a net lease REIT that has typically been priced at a ~10% dividend yield. Yet, it has done very poorly relative to other lower-yielding net lease REITs like Agree Realty Capital (ADC), which only offered a ~4% yield most times:
That's because REITs are total return investments, and growth and appreciation are even more important than the dividend yield. It is much better to focus on REITs that pay a reasonable dividend that's well covered and growing than a REIT with a high but potentially unsustainable dividend.
Lesson #2: Paying a Premium for Quality is Well Worth It
Generally speaking, the lower the valuation, the higher the potential return. This will often push REIT investors to buy REITs that trade at low multiples of their cash flows and high dividend yields.
But this is often a mistake. Warren Buffett has famously said that “it is better to buy a wonderful business at a fair price than a fair business at a wonderful price,” and this applies particularly well to the REIT sector.
Yes, the wonderful REITs typically won’t trade at the lowest valuations, but they may still outperform over the long run because of their stronger growth prospects.
To give you an example, EastGroup Properties (EGP), nearly always trades at >20x FFO, and yet, here are its returns over the long run:
This is because it owns some of the very best assets in its segment, and this has led to faster rent growth. In this case, paying a premium for quality was well worth it over the long run, and more often than not, it is those premium quality REITs that outperform over the long run. Ideally, you would seek to buy such REITs discounted if and when they face some temporary setbacks and the market overreacts.
Lesson #3: Lower Leverage Outperforms High Leverage
This may also seem counter-intuitive, but REITs with conservative balance sheets have outperformed those that were more aggressive over the long run.
This is because of two main reasons:
- Firstly, leverage is a double-edged sword. Lower leverage leads to lower returns during the good years, but it also reduces losses during bear markets. On average, lower leverage outperforms over the full cycle as you avoid catastrophic scenarios.
- Secondly, lower leverage also allows you to play offense when others are facing distress during times of crisis. Being able to buy properties at steep discounts leads to strong returns, even despite the lower leverage.
So don’t make the mistake of blindly buying highly leveraged REITs thinking that their high leverage would result in higher total returns. Historically, this has not been the case.
A great example of this is BRT Apartments (BRT), a highly leveraged apartment REIT that strongly outperformed the good years, but then crashed harder than its peers during the most recent bear market, and as a result, it has now underperformed on average.
Lesson #4: Big Size Can Be a Disadvantage
Typically, bigger is better. It results in economies of scale, better diversification, and improved access to capital, possibly at a lower cost as well.
However, past a certain point, size can also become a disadvantage because it makes it harder for the REIT to grow. The bigger you are, the more assets you must acquire every quarter to keep growing and past a certain size, this can become very challenging. The REIT may then be forced to expand into new property sectors, losing its focus, and becoming a jack of all trades. It also reduces the REIT’s ability to be selective and lowers its bargaining power with property sellers.
I have previously explained that I think that Realty Income (O) is facing this issue today. I believe that its massive size is a disadvantage because it is likely to slow down its growth going forward, and it also increases risks since the REIT has to step into new property sectors to find enough acquisition opportunities. For this reason, I prefer to invest in some of its smaller peers.
Lesson #5: The Best REITs Have Unique Business Models
This may seem like common sense, but if you want to outperform, you cannot follow the same boring strategy that most other investors follow.
As an example, there is nothing exceptional about simply buying a stabilized apartment community and, therefore, you likely wouldn’t earn exceptional returns by doing that.
You need to have a strategy that creates more value to have a chance of earning above-average returns.
A good example that comes to my mind is Essential Properties Realty Trust (EPRT), which is a net lease REIT that focuses on properties that are occupied by smaller tenants, and it originates its own deals by cold calling property owners and offering them sale and leaseback solutions. This is a unique approach that’s difficult to replicate, but that has the potential of earning above-average returns as there is little demand for these assets and the REIT gets to draft its own leases in ways to maximize returns and minimize risks.
We only seek to invest in REITs like EPRT that have exceptional business models that can consistently deliver alpha-rich returns over the long run.
Closing note
New REIT investors will often think that the differences from one REIT to another are fairly small. But in reality, just because two companies are structured as REITs does not mean that they have anything in common.
Just consider the example of Industrial Properties Logistics Trust (ILPT) vs. Prolongs (PLD). Both are industrial REITs. Yet, their long-term performance is the polar opposite:
ILPT offered a much higher yield and has traded at a lower valuation than PLD ever since it went public, but it also used much more leverage and failed to create value for its shareholders. It is a perfect example of why it is so crucial to be selective when investing in REITs.
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