I have been investing in Real Estate Investment Trusts (REITs) for over 10 years, and I have done quite well over time.
I have managed to beat the sector averages (VNQ; IYR) and earned strong returns and significant dividend income.
But I have also made many mistakes along the way, some of which were very painful. Looking back, most of these mistakes could have been avoided had I known more about REITs before I got started.
In today's article, I want to offer you the opportunity to learn from my losses so that you don't have to learn the hard way.
Here are 5 must knows before buying REITs:
Must Know #1 - Lower Leverage = Higher Returns
It may seem counterintuitive.
You would think that higher leverage would result in higher returns over time, but it has actually been the opposite in the REIT sector.
The conservatively financed REITs have outperformed the aggressively financed REITs in most cases over the long run. That's despite typically offering much lower dividend yields and trading at higher valuation multiples.
Why is that?
There are two main reasons why this actually makes sense.
Firstly, leverage is a double-edged sword. Yes, higher leverage may result in higher returns during times of economic expansion when everything is sunshine and rainbows. But good times never last and when times get tough, high leverage can quickly wipe out years of returns. Therefore, by being more conservatively financed, you may fall behind a bit during the good times, but you don't lose as much during the bad times, and on average, you end up earning higher returns in many cases.
Secondly, the best deals are typically made when times get tough, and being conservatively financed then allows you to acquire assets at cheap prices when others are facing distress and forced to sell assets to deleverage.
With that in mind, it is generally preferable to stick to conservatively financed REITs. Most of my holdings have an LTV of around 40% and long and well-staggered debt maturities. They are not the highest-yielding or the cheapest REITs, but I would expect them to outperform their more aggressively-financed peers over the long run.
To give you an example: Agree Realty (ADC) has consistently used less leverage than Gladstone Commercial (GOOD) and yet, it has earned much better returns, despite focusing on the same property sector:
Must Know #2 - Management Is The Single Most Important Thing
If the management is conflicted, then nothing else matters.
The REIT may own the best assets, have the strongest balance sheet, and trade at a low valuation, but that's all irrelevant if the management is poorly aligned with shareholders because they will always find a way to extract more value from you.
I would much rather invest in a REIT that owns subpar properties but has a shareholder-friendly management team than the opposite.
The example of this is perhaps Industrial Logistics Properties Trust (ILPT).
The REIT owns highly desirable industrial properties that have enjoyed strong rent growth over the years and gained significant value. The same is true for most of its peers like EastGroup Properties (EGP), Prologis (PLD), and Rexford Industrial (REXR).
But their results are day and night. ILPT has almost gone bankrupt because the management got greedy and took on too much leverage in an attempt to grow the portfolio as much as possible as this would justify higher fees for themselves.
As a result, they are today on the brink of bankruptcy as a result:
Never invest in a REIT that's poorly managed. ILPT owned great assets and the management still managed to mess it up.
Must Know #3 - Cheap Can Get Cheaper
Another mistake that I have made was to think that the valuation was so low that the downside was protected.
After all, if a REIT is priced at a 50% discount relative to the fair value of its assets, how much lower can it really go?
Typically, REITs are priced at a small premium to their net asset value so such low valuations should provide margin of safety.
But believe me when I say that cheap can get cheaper.
I learned this lesson with CBL & Associates (CBL) many years ago. Back then, CBL offered a 10%+ dividend yield that was seemingly sustainable and it traded at just 4x its cash flow.
I thought that the low valuation would provide margin of safety.
But that wasn't the case. Its share price just kept dipping lower and lower. The lesson is that if a REIT is priced at such a very low valuation, there is typically a good reason for it. If it sounds too good to be true, it probably is.
Since then, I have focused more on "quality value" rather than "deep value" and this has greatly improved my performance.
Must Know #4 - Timing The Market is Not Possible
When I read comment sections of SA articles on REITs, I often get the feeling that investors think that they can time the market.
As an example, I cannot tell you how many times I have read that you shouldn't buy REITs due to rising interest rates or that you should wait for rate cuts before buying REITs.
But if timing the market was really that simple, we would all be billionaires.
In reality, it is far more complex than that.
You may be surprised to hear this but studies show that REITs have actually generated strong positive total returns in the 12 months following interest rate hikes on average. They have also outperformed the S&P500 (SPY) during most times of rising interest rates:
Yes, this wasn't the case in the most recent rate hiking cycle, but this proves my point that timing the market isn't possible.
Must Know #5 - Value in Crisis
The final point that I want to make here is more about missed opportunities.
I have at times missed some great investment opportunities because I let a temporary crisis scare me.
All companies, including REITs, will occasionally go through temporary crises and that's often when their valuation will be the lowest and their shares will be the most opportunistic. Even Warren Buffett's Berkshire Hathaway (BRK.B) has dropped by over 50% many times in its history.
That's the time to be a buyer.
To give you an example: W. P. Carey (WPC) is today very cheap because it just recently spun off its office properties into a separate REIT and cut its dividend. The market did not like the dividend cut and as a result, it is discounted.
But this is really just a case of short-term pain for long-term gain. WPC is now left with its best assets and it will enjoy faster growth prospects going forward. Despite that, it is now cheaper and I think that it will only be more rewarding because of it.
The key is to think long-term. Real estate should be valued based on decades of expected future cash flow and therefore, temporary crises really shouldn't have a significant impact on the valuations of REITs.
Closing Note
The REIT sector is vast and versatile with over 200 companies in the US alone and they invest in over 20 different property sectors.
But realistically, over 80% of these REITs probably aren't worth buying. Many are overleveraged, poorly managed, and/or overpriced.
If you want to avoid losses and improve your returns, you need to be very selective.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
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