2023-08-03 08:05:00 ET
Summary
- New investors often make costly mistakes when investing in REITs.
- Some of these mistakes could be easily avoided with some education.
- I highlight 6 important mistakes that I have made in the past.
Right now, I see a lot of new investors flock into the real estate investment trust, or REIT (VNQ), sector and it is pretty simple to understand why:
- They are now priced at historically low valuations and high dividend yields after seeing their share prices crash even as their cash flows kept on rising over the past year:
Most investors understand that the best time to invest is shortly after a crash when valuations are cheap and this is the case here.
According to an analysis by the investment firm Janus & Henderson, REITs are now priced at a near 30% discount to their net asset value, which essentially means that you get to buy equity in real estate at 70 cents on the dollar.
These valuations are reminiscent of the great financial crisis!
But before you rush into REITs and buy just anything, I want you to take a step back and recognize that this is a vast and versatile sector with many landmines.
Just because most REITs are now attractively priced does not mean that all REITs are good investment opportunities.
On the contrary, this is a sector in which you need to be particularly selective because there are many companies that are overleveraged, poorly managed, and/or exposed to challenged property sectors. There are lots of companies that seem very compelling on the surface, but once you dig a bit deeper, you quickly realize that not all that glitters is gold.
In what follows, I will highlight some common mistakes that I see a lot of new REIT investors making. I have now been doing this for over 10 years, and trust me when I say that I have made lots of mistakes along the way, lost lots of money in bad REIT investments, and I am today a much better investor for it.
Learn from my costly lessons, so you don't have to learn the hard way like I did:
Mistake #1: Ignoring non-revenue-enhancing capex
This is a big one that gets little attention.
Most REITs need to reinvest a portion of their cash flow into their properties in order to maintain them in good shape and keep them desirable. It does not boost their cash flow any further, and this is why we call it "non-revenue-enhancing capex."
In most cases, this is not very significant. It may be between 10-20% of their NOI depending on the property sector, the lease agreement, the quality of the tenant, and the age of the properties. To give you an example, it is about 10-20% in the case of Alexandria Real Estate ( ARE ):
This level of capex is an acceptable cost of doing business.
But then there are some other cases when the capex is far greater, and it can also change drastically over time.
Today, a lot of investors are buying office REITs because their valuations seem very low based on their current cash flow. For instance, SL Green ( SLG ) is priced at just 6.5x FFO.
But that ignores all the non-revenue-enhancing capex that these REITs will need to put into their properties in the coming years just to keep them occupied.
This capex will likely grow significantly in the coming years because there is now an enormous amount of oversupply in the office sector, the needs of tenants are changing, and landlords will need to make significant concessions to keep their tenants happy.
Once you adjust for this capex, the valuation metrics aren't always that compelling anymore. Moreover, it also negatively impacts their leverage and dividend payout metrics. This explains why so many office REITs have recently cut their dividends.
Interestingly, we saw the exact same thing happen to mall REITs years ago, but few investors appear to have learned from them. Back then, I didn't pay enough attention to the growing capex needs for malls and made the mistake of investing in them. They seemed cheap, but they end up turning into value traps. I fear that many office REITs will face the same fate.
Mistake #2: Assuming that all REIT managers have your best interest at heart
Everyone knows that some REITs are better managed than others.
But it seems to me that investors are still underappreciating the vast differences in quality and interest alignment from one management team to another.
It is literally the most important factor of all because a bad management team will always find a way to destroy value, regardless of the other attributes of the REIT.
Take the example of Industrial Logistics Properties Trust (ILPT): this REIT owns highly desirable industrial properties and land in Hawaii that enjoy growing rents and demand, but that doesn't matter because the management has made bad choice after bad choice, diluting shareholders and pursuing deals that end up hurting them. Compare its performance to that of another industrial REIT that's well-managed like EastGroup Properties (EGP).
EGP has always been priced at a 2x or even 3x higher funds from operations, or FFO, multiple than ILPT. However, as you can see, the higher valuation is well-justified. If you cannot trust the management, then the rest is irrelevant.
Mistake #3: Buying mREITs instead of eREITs because of their higher dividend yields
Many investors are attracted by the high dividend yields of REITs and end up buying mostly mortgage REITs, or mREITs in short because they offer materially higher yield levels than traditional equity REITs, or eREITs.
It is not uncommon to find 10% yielding mREITs (MORT) in today's market, but eREITs only yield about half of that in most cases.
Many are quick to assume that a higher yield = higher return, but this couldn't be further from the truth.
mREITs have historically been some of the worst investments over the long run, earning just 2% annual total returns, even despite offering these juicy yields. They are in the business of lending money, but they haven't been able to successfully predict the movements of interest rates and spreads, they have used too much leverage, and often suffer significant conflicts of interest:
eREITs, on the other hand, have done a lot better, generating very compelling total returns because they have managed to grow their cash flows in addition to paying dividends. It shows you that the business of being a landlord and collecting rent is a lot more consistent and less reliant on external factors like interest rates and spreads.
Take the example of VICI Properties (VICI), which is the biggest casino REIT in the world.
It only yields 5%, but it has been able to grow its dividend by nearly 10% in most years, and this has resulted in very compelling total returns.
This year, it has again guided to grow its cash flow by 10%, and so you can easily estimate its total return potential:
5% dividend yield + 10% growth = 15% total return, assuming that its valuation multiple remains intact.
This is roughly what they have achieved since going public. There are very few mREITs that have beaten these results even despite offering a 2x higher dividend yield. Don't fall for the yield trap.
Mistake #4: Focusing too much on a few specific REITs
A lot of investors fall in love with one or a few ideas and invest very heavily in them.
A good example of that would be Medical Properties Trust (MPW). It is a very popular REIT on Seeking Alpha, and I myself own a position.
But just because you like a REIT does not mean that you should put all your eggs in one basket. All REITs have risks and you could suffer significant losses if risk factors play out.
This is why diversification is so important.
At High Yield Landlord, we hold 24 REITs in our Core Portfolio and we have found that 15-25 REITs is the ideal range to maximize gains while minimizing risk. Beyond 25, you start to dilute your exposure to your favorite ideas, and below 15, you get overexposed to the risks of some individual REITs.
Mistake #5: Forgetting about international REIT markets
Most REIT investors never look beyond the U.S., and that's a big mistake in my opinion. There are REITs in over 30 countries today, and the best opportunities are often found in foreign markets since they are less competitive:
Just recently, we sold our biggest Canadian REIT investment, Boardwalk REIT (BOWFF), and pocketed a 157% total return:
It just shows that foreign REIT investments shouldn't be ignored. They can boost your returns all while lowering your risk at the portfolio level.
Mistake #6: Looking at the wrong metrics and ignoring important ones
A lot of new REIT investors focus mainly on FFO per share, which is a rough representation of the cash flow that a REIT is generating. Secondly, they will focus a lot on the dividend yield and the payout ratio to assess if the dividend is sustainable.
But this is far too simplistic if you want to identify the best opportunities.
Instead, investors should adjust for capex and focus more on AFFO multiples, and secondly, they should come up with net asset value estimates to really understand how much they are paying for the real estate.
These metrics are, of course, harder to find and this is why most investors aren't paying attention to them. You may need to spend hours calculating them yourself and/or subscribe to a paid research subscription, but it is well worth it if you are serious about REIT investing.
Invest in REITs like a Real Estate Landlord
We aim to invest in REITs as if we were buying rental properties.
- We want good real estate that's not heavily dependent on capex.
- We want managers that have skin in the game.
- We look for growth opportunities to not just rely on the current yield.
- We diversify appropriately to optimize our risk-adjusted returns.
- We don't ignore foreign REITs because they are often the most rewarding.
- And finally, we always try to get a good deal, buying real estate at a steep discount to its fair value.
For further details see:
What I Wish I Knew Before Investing In REITs