I have invested in real estate investment trusts, or REITs, for well over 10 years, and overall, I have done quite well over time. My REIT portfolio has significantly outperformed the average of the REIT sector (VNQ, RMZ) and this relatively strong performance has allowed me to become a professional REIT investor.
But I have a lot of mistakes along the way, some of which have cost me a lot of money.
In today's article, I want to give you some tips that I wish I had known before I got started in REIT investing because it would have saved me from many losses and my performance would have been stronger.
Here are 5 important lessons for every REIT investor:
#1 - Deep Value Situations Rarely Pay Off In The REIT Space
My biggest mistake has probably been to focus too much on valuation and not enough on fundamentals. This led me to invest in a lot of deep value plays over the years, and while some of them worked out well, most of them didn't.
CBL & Associates Properties, Inc. (CBL) is the best example. This mall REIT was trading at a low single-digit multiple of its cash flow in 2018 and its malls were producing stable cash flow. We understood, of course, that its assets were facing some challenges, but we thought that the ultra-low valuation would provide a good margin of safety. In reality, the valuation wasn't that low because we had not properly taken the capex into account.
Other examples include Uniti Group (UNIT) and Medical Properties Trust (MPW). I still hold hope for these two REITs, but they are very risky and I have certainly been wrong so far.
The point here is that the market may not be perfectly efficient, but it is not completely stupid, either. If it seems too good to be true, it probably is.
As Warren Buffett famously said: "it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
This applies well to REITs. It does not mean that you should only buy the highest-quality REITs and accept whatever price. But you probably shouldn't reach for the cheapest, lowest quality REITs either.
Being too greedy has cost me a lot in my REIT investing career.
#2 - The Business Model is The Most Important Thing
Investors tend to forget that REITs are active real estate investment firms and not just passive holding companies.
Therefore, the business model, or put differently, the strategy of the management, is very important to understand.
You want to buy REITs that follow unique strategies that have the potential to generate exceptional returns, and not REITs that are simply following the same cookie-cutter approach to real estate investing that countless other investors are following.
I recently discussed this topic in an exclusive interview with Chris Volk, who is the former CEO of STORE Capital. This was a truly exceptional REIT that we used to own until it got bought out by private equity:
Chris Volk explains that: "Having been instrumental in guiding three net lease REITs, I learned the importance of getting the business model right at the outset." (On a side note: in case you haven't already, you should consider buying Volk's new book "The Value Equation." It is very useful for REIT investors).
From my experience, it is well worth it to pay a premium valuation for a REIT that has a superior business model because it will create so much more value over the long run.
A good example today would be Essential Properties Realty Trust (EPRT) versus Realty Income (O). Both are net lease REITs, but EPRT is far smaller, focuses on middle-market companies, and is able to earn larger spreads on its new investments:
O, on the other hand, is getting too big for its own good and cannot keep up anymore with the smaller and more creative peers like EPRT.
The differences in their business model explain the vast outperformance.
#3 - Volatility Can Be A Gift Or A Curve
In my early days, I recall overreacting a few times to volatility that was caused by market noise. As an example, I recall selling a REIT because it had posted disappointing quarterly earnings.
But over the years, I learned that good REITs typically bounce back, and acting based on short-term news is often a bad decision.
This also makes logical sense.
REITs should be valued based on decades of expected future cash flow, and therefore, the real impact of a bad quarter or even year, really shouldn't be that significant.
Every REIT, without exception, will suffer occasional setbacks, whether it is a tenant vacating a building and causing the REIT to miss quarterly expectations, or a tenant going bankrupt, causing the REIT to lose rental income in the near term.
The market will often overreact to such news and cause the share price of the REIT to crash. We just saw this with W. P. Carey Inc. (WPC) following its Q4 result announcement:
From my experience, these are often great buying opportunities, and inversely, they are very poor times to sell a REIT.
Don't overreact to short-term news. If you have a long-time horizon, you can take advantage of such volatility.
#4 - The Dividend Should NOT Be An Important Factor
A lot of REIT investors focus too way much on the dividend yield.
They think that a high dividend yield implies that a REIT is cheap and a good investment opportunity.
In reality, it is often the opposite, and the dividend does not say much, if anything, about the valuation of a REIT.
The dividend is just a capital allocation decision. A REIT may decide to use a lot of leverage and set a high payout ratio to pay a larger dividend. Or it may simply use less leverage and retain more cash flow for growth - resulting in a lower yield.
Historically, the REITs that have had very high dividend yields have actually underperformed the lower-yielding REITs. A good example here is Global Net Lease (GNL). The REIT attracts a lot of individual investors because it offers a very high dividend yield, but here are its total returns over time:
What's the point of earning a 15% dividend yield if that leads to simultaneous value destruction?
It is generally much better to buy lower-yielding REITs that enjoy strong growth prospects than the opposite.
Closing Note
Not all REITs are created equal.
This is a vast and versatile sector with a lot of great opportunities, but also many value-traps.
There are large differences in performance from one REIT to another and you need to learn how to separate the good from the bad ones.
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