BYLOF - What I Wish I Knew Before Buying REITs

2024-01-04 08:25:00 ET

Summary

• REITs have historically been very rewarding investments.
• But this is a vast and versatile world with many landmines.
• I have learned many lessons the hard way. Here are 5 tips to avoid investing in the wrong REITs.

REITs are some of the most popular investment vehicles among individual investors. According to NAREIT , nearly every second household in the US invests in REITs and it is pretty simple to understand why:

• They have historically outperformed most other investments, including even the S&P 500 ( SPY ), growth stocks ( SPYG ), and private real estate...
• That's despite being safer than most other investments...
• And providing significant dividend income, inflation protection, and diversification benefits to a portfolio.

Therefore, it may seem like a no-brainer to include a REIT allocation in an overall portfolio strategy.

But before you buy just any REIT, you need to recognize that this is a vast sector with over 200 companies, and there are significant discrepancies from one REIT to another. Just to give you an example, over the past three years, Prologis ( PLD ) has been very rewarding to its shareholders, but its smaller peer Industrial Logistics Properties Trust ( ILPT ) almost lost it all:

Therefore, if you are going to build a REIT portfolio, it is crucial that you select the right ones. Here are 5 things that I wish I knew before I started buying REITs. It would have saved me a lot of money!

#1 - The Dividend Yield Should Be Just An Afterthought

This may be the most important thing on this list.

A lot of REIT investors, including even the more sophisticated ones, will put way too much emphasis on the dividend yield, thinking that a higher yield will result in higher returns over time.

But in reality, it is often the opposite.

A lot of the highest-yielding REITs are only offering a higher yield because:

• Their payout ratio is too high
• They use a lot of leverage
• Own riskier assets and suffer poor growth prospects

In the end, the total returns of high-yielding REITs often end up being lower than those of lower-yielding REITs that have more conservative payout ratios, use less leverage, and enjoy better growth prospects.

Just to give you an example of a REIT that lost me a lot of money:

Medical Properties Trust ( MPW ) has long been a popular high-yielding REIT, but here is how it has performed over the past year:

On the flip side, here's the performance of Welltower ( WELL ), which is another healthcare REIT that offers a much smaller dividend yield:

The point here is that the dividend yield says very little about the expected returns of a REIT. The dividend is just a capital allocation decision and therefore, it should be just an afterthought.

It has no impact on the value of the assets and says nothing about the actual fundamentals of the company.

#2 - Many REITs Are Uninvestable Due To Conflicts of Interest

REITs have existed in the US since the 60s and they are today highly scrutinized by the SEC and countless analysts. They are also governed by a board of directors that represents the shareholders, and the management typically owns a large equity stake in the REIT.

Therefore, most REITs are today managed in the best interest of shareholders.

But there is still a minority of REITs that suffer significant conflicts of interest and as a result, they have been recurrent underperformers over the long run.

This is true for a lot of the externally managed REITs that outsource their management to outside asset management companies. They will typically earn fees that are tied to the volume of assets under management and as a result, they will be incentivized to grow at all costs, raising capital, and buying more properties, even if the new investments are dilutive on a per share basis.

In my opinion, a good example of this in the past has been Global Net Lease ( GNL ). It has consistently issued more shares, which led to higher management fees, but diluted shareholders and led to a steadily declining share price.

Today, GNL seems to be better managed, but it is a good example that if a management team is conflicted, then the REIT is uninvestable.

If you will get constantly diluted, then the rest of the story is irrelevant.

#3 - Cheap Can and Will Often Get Cheaper

There are a lot of REITs that are priced at irresistible valuations, and a lot of investors will make the mistake of thinking that if something is priced at a large discount relative to the fair value of its real estate, then you cannot lose money.

After all, this would mean that if the REIT is liquidated, you would still make money after it pays off its debt.

But it is not that simple.

First of all, net asset values are highly subjective calculations. You may estimate that something trades at a 50% discount, but small changes to your assumptions could compress the discount to just 20-30%, especially if the REIT is highly leveraged.

Secondly, if the situation at a REIT gets so bad that it needs to be liquidated, then the net asset value will likely end up being much lower in a liquidation since the REIT will be under pressure to sell the assets and the buyers will take advantage of the situation.

Finally, the assets may simply decline in value. Office REITs are a great example here. Today, they are priced at large discounts based on yesterday's cap rates, but as cap rates expand, the discounts could quickly disappear.

So don't make the mistake of thinking that a large discount to NAV will shield you from losses. Cheap can and will often get cheaper.

#4 - The Best Opportunities Are Often Found In Smaller and Lesser Known Companies - Not In The Most Famous REITs

Large REITs are scrutinized by far more analysts because most institutions need a certain amount of liquidity and cannot easily build positions in smaller REITs.

As a result, smaller REITs are often left to smaller institutional investors and retail investors, and since there is less demand for their shares, relatively speaking, they tend to trade at lower valuations than their larger peers.

The spread is especially large today:

There is also far less research available on the smaller REITs and as a result, pricing inefficiencies are more frequent.

This means that active investors who aren't managing $10s of millions can often find some great deals in the small-cap segment of the REIT market.

Just to give you an example, we recently started building a position in Northview Residential REIT ( NRR.UN:CA ), which is a new micro-cap apartment REIT. It was trading at a 50% discount to its net asset value when we identified the opportunity and we think that this is in large part because its float is tiny and most investors simply cannot buy it. Since then, it has already increased by about 20% in just a few weeks.

#5 - Opportunities Are Abundant in Foreign Markets

Most investors focus on the US market, which is by far the biggest.

But there are 30+ other countries that have REITs or REIT-like entities:

There are about 200 REITs in the US but there are nearly 1,000 worldwide.

And since REITs are fairly new vehicles in a lot of these foreign markets, there are fewer analysts covering them, and more frequent pricing inefficiencies.

To give you a simple example: we think that the self-storage market is today overbuilt in the US. The competition is fierce and properties have been built all over the place. But some foreign markets are far more attractive. There is 10x less storage space per capita in the UK and far better growth opportunities but despite this, the leader in the UK, Big Yellow Group (BYG / BYLOF ), is today priced at a similar valuation as the leader in the US, Extra Space Storage ( EXR ).

Closing Note

REITs can be very rewarding investments if you know how to select the right ones. I have been an active REIT investor for over 10 years and I have made many mistakes along the way to learn these lessons. Read this again if needed so that you don't have to learn the hard way like I did.

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