BDN - Sell Alert: 3 REITs Getting Risky

2023-07-27 08:05:00 ET

Summary

• REITs are now cheap and they are attracting a lot of new investors.
• But being selective is very important in this sector.
• I highlight three REITs to avoid.

I am now seeing increasingly many new investors flock into real estate investment trusts, or REITs ( VNQ ), and I see most of them make the same mistakes:

• They are buying poorly managed REITs that offer high dividend yields.
• They are buying the biggest and best-known REITs at high valuations.
• They are overlooking the impact of capex on dividend coverage.

And as a result of these mistakes, I believe that many new investors are poorly selecting their REIT investments and leaving a lot of money on the table, or worse, exposing themselves to significant potential losses.

Here are three REITs that I would consider selling if I owned them today:

Office Properties Income Trust ( OPI )

This is a good example of a high-yielding REIT that's poorly managed.

It has always been offered at a low valuation and high dividend yield and despite that, here are its long-term results:

It just goes to show that simply getting a REIT at a low valuation does not mean that you are going to earn high returns.

A poorly aligned management team will always find a way to destroy or extract value for themselves, and this is what has really happened here.

They have consistently issued a lot of shares over the years at highly dilutive prices because this would allow them to buy more properties and justify higher fees for themselves. But take a look at the results:

Today, once more, new investors are getting lured into poorly managed REITs like OPI because on the surface they look very compelling. OPI offers a 12% dividend yield and they just reaffirmed the dividend earlier this month!

But with a conflicted management team, it wouldn't matter if the yield was 20%, it still wouldn't be investable in my opinion.

And even ignoring the management for a second, OPI is facing lots of challenges:

• It owns a lot of single-tenant office buildings that are at high risk of seeing their rents drop and they will also face a huge amount of capex in the coming years just to keep them occupied.

• They have too much leverage in today's rising interest rate environment. A high-quality office REIT called Piedmont Office Realty ( PDM ) recently refinanced some debt at a 9.25% interest rate! OPI owns lower-quality assets and could face bankruptcy if all of its debt had to be rolled at such high interest rates.

• Finally, it is in the process of merging with another REIT called Diversified Healthcare ( DHC ), and this merger seems very fishy to me. This second REIT is managed by the same manager and news recently came out that it is facing an event of default , which could push it into bankruptcy. It seems that the manager is attempting to merge both entities to save DHC and not lose the fee income that it is getting from it.

Anyway, if there is anything for you to take away from this article, it is that you should stay away from poorly managed REITs. An easy sign to spot such REITs is whether it is internally or externally managed. Externally managed REITs typically suffer much greater conflicts of interest.

Welltower Inc. ( WELL )

The second mistake that many investors are making is to simply buy the biggest and best-known REITs, regardless of their valuation.

I think that WELL is a good example of that.

It is the biggest healthcare REIT in the world, owning over $50 billion worth of senior housing communities, skilled nursing facilities, and medical office buildings.

It is a high-quality REIT with a strong track record, desirable assets, and a defensive balance sheet , but you still need to ask yourself: what price am I paying?

Today, the REIT is priced at 23.4x FFO, a low 2.9% dividend yield, and a slight premium to its net asset value.

At the same time, some of its smaller and lesser-known peers are priced at materially lower valuations:

• Healthcare Realty ( HR ), as an example, which is the leader in the medical office segment, is today priced at just 12x FFO and a 6% dividend yield.
• Omega Healthcare ( OHI ), which is the leader in skilled nursing facilities, is priced at just 10x FFO and an 8% dividend yield.
• Finally, National Health Investors ( NHI ), which owns a lot of senior housing facilities, is today priced at just 12x FFO.

The valuation differential is massive, and I would expect investors who buy the larger and better-known REIT to underperform over time because they are simply paying too much for it.

Brandywine Realty Trust ( BDN )

Finally, a third common mistake is to ignore or at least underappreciate the impact of capex on dividend coverage and sustainability.

BDN is a good example of that.

It is today attracting a lot of investors because it is priced at a 17% dividend yield and its payout ratio seems very reasonable at 66% based on its FFO (funds from operations, a measure of cash flow that's commonly used in the REIT sector).

But this would ignore the capex.

BDN owns a lot of older office buildings that will require a lot of capex and TI to keep them desirable to tenants as leases gradually expire in the coming years. It is going to cost them a lot, and when you adjust for that, the dividend payout ratio quickly rises above 100%, making it unsustainable in my opinion.

The REIT also has a bit too much leverage and needs to pay off some debt, which worsens its dividend sustainability even further.

That, of course, doesn't mean that BDN is a bad investment opportunity. It could do well over time because it is now so heavily discounted but don't make the mistake of buying it for the dividend.

Since so many investors are making this mistake today, I fear that BDN will see its share price drop quite a bit when it finally cuts the dividend and investors run away.

Bottom Line

REITs are today priced at their lowest valuations and highest dividend yields in many years and this is attracting a lot of investors.

But don't make the mistake of buying just any REIT.

Get educated before you get started. Read some articles. Buy a book on REIT investing. Subscribe to a research service... The cost of that education will be very small relative to what it would cost you in losses if you do this poorly.

For further details see: