GOOD - The Naughty List: 2 REITs To Avoid At All Costs

Summary

• Want Santa to bring you gifts?
• Then, “You’d better watch out. You’d better not cry. You’d better not pout. I’m telling you why."
• Your Elf on the Shelf is watching, after all.

“Will Santa bring coal again like last year?”

That’s a question “Real-Time Retired Guy” asked me the other day. And my answer was a resounding yes.

Then again, if he had asked me if Santa was going to bring awesome presents and good cheer again like last year, I would have responded the same. Because, as the legend goes, the patron saint of Christmas doesn’t just bear gifts.

He also meets out well-deserved punishments.

Focusing too heavily on just one rather misses the point, as any parent whose had or has young children knows.

Consider the much more recent phenomenon known as “Elf on the Shelf.” According to its official website :

“The Elf on the Shelf® is a fun-filled Christmas tradition that has captured the hearts of children everywhere who welcome home one of Santa’s Scout Elves each holiday season. The magical Scout Elves help Santa manage his nice list by taking note of a family’s Christmas adventures and reporting back to Santa at the North Pole nightly. Each morning, the Scout Elf returns to its family and perches in a new spot, waiting for someone to spot (it). Children love to wake up and race around the house looking for their Scout Elf.”

Clever, right?

I’m sure some of you reading that wish the idea had come around years before considering what an affective behavioral check it can be.

Want Santa to bring you gifts? Then, “You’d better watch out. You’d better not cry. You’d better not pout. I’m telling you why…”

Your Elf on the Shelf is watching, after all.

All I Want for Christmas Is a Fly on the Wall

Just like there are parents of grown children grimacing at memories past, I’m sure some of you reading about Elf on the Shelf wish it was so easy with investing.

Wouldn’t it be nice if there was such a simplistic way of reporting on companies’ day-in and day-out behavior? Something beyond quarterly reports and press updates?

Unfortunately, I can’t promise you a fly-on-the-wall analysis of any company.

But I can offer you my experienced, boots-on-the-ground-based evaluations and analysis of particular companies. I may not be an Elf on the Shelf, but the perch I do command shouldn’t be taken lightly.

I have my Bachelor of Science in business and economics, yes, but that’s just for starters. I believe book-learning and classroom education are important – as evidenced by the fact that I guest lecture at noteworthy schools such as UNC, Penn State, Clemson, Cornell, Georgetown, etc... – but it’s not nearly enough.

That’s why I’m proud to say I also have two decades of up close and personal experience with the kind of real estate I recommend. While I was never a real estate investment trust ('REIT') myself, I did buy (from REITs) and sell (to REITs).

I also designed and built commercial real estate ("CRE") for other major companies, as well as more mom-and-pops. I guess you could say the I learned the subject of value creation literally "from the ground up."

That makes me intimately familiar with the construction side of how REITs do business and the landlord side as well.

I’ve crunched the real estate numbers every which way. I’ve assessed literal angles when deciding where to build and how.

I’ve been a fly on the wall before. And I’ll pass that buzz on to you.

One of the Most Effective Schools to Attend

I can’t say having an additional degree from the School of Hard Knocks is as important as everything above. But it definitely doesn’t hurt.

You, that is. It doesn’t hurt you. Or me in the present.

Losing my CRE empire in the 2008 crash definitely hurt back when it happened, however. And building myself back up from there wasn’t always a pleasant experience either.

But because of that lost money, lost time, and lost effort, I ultimately learned a lot. A lot I would never give up. I’m happy where I am today, sleeping well at night knowing that not only have I rebuilt an empire…

It’s a sustainable one this time.

That recognition and reality is priceless.

So is sharing my insider "been there, done that" insight with you all. Just because I ended up on the Naughty list and got coal in my stocking a decade and (almost) a half ago, doesn’t mean you should too.

While I’m grateful for my hard knocks – since I don’t think I would have learned my lessons any other way – I’d prefer that you go straight to the Nice list. (How’s that for a mixed metaphor?)

In which case, here’s your investment Elf on the Shelf-ish take on that coal we started this article talking about…

2 Naughty REITs to Avoid

In 2023 we expect to see several REITs become challenged with higher leverage and cost of capital. Although we see opportunity with higher quality names like Realty Income ( O ) and Digital Realty ( DLR ), we believe several of the smaller REITs will suffer as a result of yield compression and refinancing risk.

One such name that screens SELL is Armada Hoffler ( AHH ), a diversified REIT with a portfolio of office, retail and multifamily assets throughout the Mid-Atlantic and Southeastern US.

As you can see above, AHH is paying out the same dividend that it did in 2016 and its earnings (AFFO per share) have essentially been flat. While most all REITs saw earnings decline during COVID-19, most have rebounded… not AHH.

As you can see below, AHH has around $1 billion of debt with more than $200 million of that coming due in 2023.

In addition, AHH’s equity cost is elevated, at 8.3%, which translates into a WACC (weighted average cost of capital) of around 6%. As debt gets repriced, AHH’s WACC will likely get closer to 7%.

One way that AHH has been able to generate higher investment spreads is by using development and mezzanine financing (11% to 15%). While these levers certainly provide the company with outsized investment spreads, they're also riskier and provide a higher degree of complexity risk.

While some analysts and investors boast of AHH’s high dividend yield of 6.5%, it’s important to consider the most important fact – AHH has not been able to grow earnings and dividends much.

Also, based on consensus analyst estimates, AHH is expected to fall in 2023 and 2024 as the company increases its WACC. We don’t expect the dividend to grow as much either.

Since 2014 AHH has returned 7.4% annualized…

Compared with these REITs:

• Realty Income ( O ): 10.0% annualized
• Mid-America ( MAA ): 13.4% annualized
• Agree Realty ( ADC ): 13.5% annualized

Given the negative growth forecast (higher WACC), higher risk earnings stream (development and mezzanine financing), and diversified portfolio, we don’t expect to see this REIT outperform in 2023. There are much better alternatives…

Another riskier REIT is Gladstone Commercial ( GOOD ).

As you can see below, and similar to AHH, GOOD has seen no earnings or dividend growth:

This earnings profile is as flat as a pancake!

Why would you want to invest in any company that’s not growing?

GOOD owns a portfolio of 137 office and industrial properties located in 27 states and leased to 112 tenants. And while the company has grown the portfolio by 18% per year since its IPO in 2003, it has seen no earnings growth whatsoever.

GOOD is also externally managed (by Gladstone Companies) and perhaps that’s part of the problem because the company is incentivized to grow assets under management…

Base Management Fee : Annual rate of 0.425% (0.10625% per quarter) of the prior calendar quarter’s “Gross Tangible Real Estate

Incentive Fee : The advisor will receive 15.0% of the amount of our pre-incentive fee Core FFO that exceeds the hurdle rate

Capital Gain Fee : A capital gain-based incentive fee that will be calculated and payable in arrears as of the end of each fiscal year. At the end of the fiscal year, if this number is positive, then the capital gain fee payable for such time period shall equal 15.0% of such amount.

Administration Agreement : Administrator’s overhead expenses in performing obligations including, but not limited to, rent and allocable portion of the salaries and benefits expenses of Administrator’s employees, including, but not limited to, CFO, treasurer, chief compliance officer, general counsel and secretary (who also serves as our Administrator’s president, general counsel and secretary), and their respective staffs.

Mortgage Financing Arrangement Agreement : Gladstone Securities collects a financing fee in connection with the services it provides to for securing mortgage financing on any of properties. The amount of these financing fees, which are payable upon closing of the financing, are based on a percentage of the amount of the mortgage, generally ranging from 0.15% to a maximum of 1.00% of the mortgage obtained.

Dealer Manager Agreement : Gladstone Securities, as dealer manager, will provide certain sales, promotional and marketing services in connection with the Offering, and we will pay Gladstone Securities (i) selling commissions of 6.0% of the gross proceeds from sales of Series F Preferred Stock in the Primary Offering (the “Selling Commissions”), and (ii) a dealer manager fee of 3.0% of the gross proceeds from sales of Series F Preferred Stock in the Primary Offering (the “Dealer Manager Fee”).

Source: GOOD 10-K

I certainly understand that it costs money to run a business, but GOOD is no longer a small cap REIT – with a market cap of around $780 million, and perhaps it’s time for the company to internalize its management team so it can grow the dividend.

Meanwhile, analysts aren’t expecting see any growth for GOOD in 2023, as seen below:

Also, using the same time period as I used with AHH, GOOD has returned a measly 6.7% annualized since 2014.

Show Me The Money

As most long-term investors know, earnings drive market performance .

Stock market gains are made through the expansion of P/FFO multiple and/or earnings growth. The earnings (P/FFO) multiple tends to be mean reverting over the long run, and therefore, earnings growth is the main driver on market returns.

W e believe that the longer-term trend will be driven by earnings and the economy . Investors must recognize the risk of a mild recession and we will be watching the sectors that are impacted the most.

Importantly, REIT fundamentals lag the economy historically by four to six months so we may not see weakening demand until mid-23 and the start of a recovery until mid-24.

In a few days we will be providing members with our annual “ REIT Roadmap ” (exclusive for our members) in which we will be provide risk analysis for all property sectors.

Rest assured, our conservative mindset will lend a critical eye toward REITs like GOOD and AHH, recognizing the potential for earnings deterioration in the near term.

Internal growth in 2023 will be more challenging for most REITs and our decision to focus on the highest quality names should benefit our readers .

We believe that the high-quality REITs will see more external growth opportunities as smaller REITs and private leveraged owners struggle with financing. The combination of macro risk and tight capital markets means investors should focus on quality and income in 2023 .

As always, thank you for reading and Happy Holidays!

Author's note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.

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