Summary
It
is well-known that REITs are our favorite asset class for high-yielding total
return investments.
Nonetheless
it is not all sunshine and rainbows. In this article, we highlight the dark
side of the REIT market.
With
a strict selection of the best REITs, most of these downfalls can be avoided
and investment performance can be materially improved.
In a recent article entitled “The Untold Truth
About Rental Investments”, I go on to explain that the reality
of rental investments is very different from their common perception. Rentals
are commonly presented as low risk/high return investments with great passive
income. In reality:
They are very work intensive with managerial
difficulties in managing the 3 Ts: tenants, toilet and trash.
They are financed with extreme leverage -
exposing investors to excessive risks.
Finally, they are illiquid, concentrated
investments with high transaction costs.
Moreover, rental investors tend to believe
that they are able to earn much higher returns. Again, in reality, REITs have
historically outperformed private real estate investments by up to ~4% per year
for the past +25 years.
By exposing these flaws of rental investments, I came to
the conclusion that the great majority of investors should favor REIT
investments over rental properties. REITs combine the positive attributes of
stocks (liquidity and low transaction cost) with the benefits of real estate
(higher income and total returns). They are completely passive investments,
provide better diversification, and are managed by professionals.
Nonetheless there is another side to every story. REITs
have their flaws as well; and while they are (by far) our favorite option for
real estate investments, there is an untold truth to be told here as well.
#1 REIT Management Teams: Dishonesty, Misalignment, and
Overpay
The REIT industry has come a long way. Back in the 70s,
it was very common for management teams to take advantage of shareholders by
charging excessive fees and doing what was right for them. Over the years as
the market kept on growing, REITs have become much friendlier to shareholders
and today, most management teams are well-aligned with significant insider
stakes and adequate pay for the value creation.
That said, there still exists a number of REITs that keep
acting in their management's self-interest. They are more worried about their
own pay than the performance of the underlying stock. The good thing here is
that it is fairly easy to spot them:
Commonly they will be
externally managed.
They will do regular share
issuances despite the deep value of their shares.
Their fees / salaries will
be directly tied to the assets under management (AUM).
This leads to what we like to call “empire building”. The
management team will seek to maximize the “size” of the portfolio rather than
its “performance” to increase their management fees which are tied to the size
of the AUM. In the worst cases, the management teams will go as far to issue
new shares at discounts to NAV to buy more properties – directly destroying
shareholder value along the way. Examples of REITs that have fallen victim to
this behavior in the past include Global Net Lease (GNL),
Office Properties Income (OPI), Select Income (SIR),
and many other.
#2 Market Inefficiencies: Volatility, Correlation and
Interest Rates
Still to this day, REITs remain deeply misunderstood by
the investment community, including professionals. Many people who
traditionally invested in real estate often do not trust – or bother to
understand the stock market, while most people who invest in stocks are
uncomfortable with commercial real estate. Put differently, REITs tend to be
perceived as stocks by real estate investors, and as real estate by stock
investors. Being a hybrid from both, has made it difficult for investors to
categorize REITs into one group and led to substantial biases as well as a
general lack of interest from the investment community.
It results in regular market inefficiencies with
excessive volatility and correlation to the broader stock market. Moreover,
investors may at time become overly worried for unwarranted reasons (ex:
interest rate hikes) and panic sell. For investors who are worried about short
term performance, this is a great concern as their REIT holdings will fluctuate
in value on a daily basis despite no changes in their fundamentals.
However, this is also an opportunity for smart and
entrepreneurial REIT investors who may achieve alpha by taking advantage of the
market inefficiencies to buy undervalued REITs when they come on sale, and sell
overpriced REITs when the market gets overexcited.
#3 Investment Result Disparities: The Need
for Professional Analysts
We often argue that managing rentals is a huge hassle.
You have to deal with tenants, property maintenance, financing, and so on and
so forth. Yet, analyzing REITs is no walk in the park either. It requires
specialist skills that are not widely available and there is a strong need for
professional research to sort out the worthwhile from the wobbly.
One easy option for REIT investing is to simply invest in
the broader REIT market, utilizing an index fund such as the Vanguard REIT fund
(VNQ).
However, this means buying every REIT in the index, regardless of its current
price, quality, prospects, or management. While “know-nothing investors” (to
borrow a term from Charlie Munger)
may find this broad diversification useful, we believe (as does Charlie Munger)
that using an intelligent analysis of the qualitative and quantitative aspects
of each REIT in order to pick and choose the most opportunistic investments
will provide the best total-returns over the long term.
At High Yield
Landlord, we spend hundreds of hours and thousands of dollars
researching the REIT market in order to target the highest quality REITs that
are being offered for sale by Mr. Market at low valuations. As a result, we are
able to achieve superior dividend yields (currently 7.86% weighted average in
our real-money portfolio) at sustainable dividend payout ratios (currently
70.4% weighted average in our real-money portfolio), thereby giving us strong
current income (enabling us to capitalize on short term volatility by averaging
down on top opportunities) and superior total returns over time.
This is not however possible for everyone. We do this
full-time, it is our only focus, we have great resources, and access to
management teams to conduct interviews.
(Disclosure: the objective ofHigh Yield
Landlord is to streamline this research process to the public
and allow interested members to emulate our strategy.)
The Bigger Picture: Why We Prefer REITs Over
Rentals
Now that the untold truth of REIT investments has been
told and everyone is aware of their flaws; it is important to keep an outlook
on the bigger picture.
REITs have historically outperformed almost all other
asset classes with spectacular returns over many market cycles. They provide
consistent high income along with long term appreciation in a perfectly passive
manner. Finally, investors enjoy high liquidity, inflation protection, and
limited liability.
While every investment has
its flaws, there are reasons why REITs are our favorite asset class. Passive
indexes have managed to provide +12.5% annual returns for decades. Active and
more entrepreneurial investors who target market inefficiencies have managed to
reach up to +22% annual returns over the same time period
This is what we aim to do at “High Yield Landlord” by
specializing in REIT investing. We want to maximize our chances of generating
high total returns with limited risk while remaining liquid and in control of
our real estate investment. We believe that the best way to achieve this is by
investing in REITs, not in private rental properties.
A Note about REIT Investing: To succeed as a REIT
investor and earn high consistent income, we recommend to:
- Closely monitor your REITs, including
quarterly NOI and FFO performance.
- Diversify your REIT portfolio with at least
ten companies (there are over 200 publicly traded REITs so please be
selective).
- Identify REITs with strong long-term
fundamentals but affected by temporary challenges causing their valuation to
decline and yields to rise.
- Be ready to take advantage of market
volatility and look for opportunistic buying points.
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