Today’s question comes from a conversation that I’ve repeated multiple times with readers. What is the difference between investing in the REIT Index (VNQ) verses Individual Real Estate Investment Trusts? The following is some commentary and my opinion and should not be taken as investment advice…
Why I Struggle With the REIT Index?
I’m usually a proponent of some index investing, but have always struggled with buying the entire Real Estate Index. There are so many different asset classes inside the REIT index and I’m already paying one fund manager by virtue of owning a Real Estate Investment Trust. The simple structure of a REIT is to pool money, buy properties, then pay a professional manager to run the company and receive a return. A REIT index is merely a fund of funds, weighted by market capitalization.
I view a traditional REIT as a real estate fund that raises equity and buys properties with more than 50% equity and less than 50% debt. Some other assets have creeped into this group, such as mortgage REITs, which don’t own the properties but instead own loans against the properties. I struggle to evaluate the risk/return relationship on mortgage REITs and instead prefer to look at the traditional companies.
I also believe the risk/return equation has changed for the next few years after Covid19. Is it really worth risking a loss of principal for an asset returning 4% or so? I believe the “equity risk premium” is now a lot more. As of this writing, there are still apartment and mini-storage REITs only paying a 3-4% dividend. To me, that is not enough of a premium to take equity risk, even if the cash flows from those assets turn out to be fairly stable.
How I Analyze a REIT:
The primary measure of cash flow in a REIT is Funds From Operations (FFO) instead of Earnings Per Share. FFO adds back depreciation and removes gains / losses from the sale of assets. I want to know the ongoing monthly cash flow from a real estate fund and FFO is that measurement. FFO should also be a good bit above the dividend payment. I then look at the company’s balance sheet. How much of their assets is real estate assets + cash? I want their balance sheet to primarily be real estate and cash. I dislike mortgages on the balance sheet, that usually means the REIT loaned to someone who couldn’t otherwise get a bank loan. That’s fine for some investors, but it is not my style. Next look at their debt position. What is total debt to total assets? Under 50% is good, some are as low as 30%. How much cash did they report at the end of the last quarter? The more cash the better right now. Specifically in this early 2020 market decline, a few REITs were lucky to sell some assets in late 2019, giving them a substantial portion of cash on the balance sheet going into this correction.
Next go to their investor relations website. Their glossy reports have a lot of fluff but good information. Who are their tenants? Do you think the tenants can survive? Where are their properties? When are their debt maturities? Does it say if any of their rent is variable or is it fixed? Look at their 12/31/2019 total equity, divide it by the number of shares outstanding, and you come up with the book value per share. What is the stock price today relative to the book value per share? Do they own the type of assets that can fall rapidly in price (such as hotels). Remember the value of the properties they report is purchase price less some depreciation each year, meaning it is understated compared to market value in a normal environment. In the depths of a market panic, some REITs will sell for below their book value and may be a good investment opportunity.
Where Are We Today?
I’m writing this on the week of March 23rd, 2020, in the depths of one of the fastest bear markets in history.
The required return for equity risk has increased. This is an important consideration in some asset classes that have been considered the “lower risk” REITs. Apartment buildings, mini-storage, cell phone towers, and timberland all fall into this category when I do a quick review of the various types of REITs. Their business may not be impacted as much from the current correction, but will they continue to receive this type of investment premium? Many of them still only return 2-4% to shareholders in dividends and earn 5-6% of their share price in Free Cash Flow per year? Is that enough of a return to take the risk?
On the other side of the risk/return equation, the lodging/resort and hotel REITs are priced far below book value, but do they have enough cash to survive? Is the value they bought their properties at even relevant now that the country has seen travel revenue go to nearly zero? What will the future of business travel be? Many retail/shopping mall REITs have a high risk profile as well. The business was already struggling and now economic activity has been put on pause. These REITs are selling at deep discounts, but are they a good value or a “value trap”? I think some names here will be like buying banks in 2009: Some survive and return multiples over their current price where others will disappear completely. If you choose to invest in this, invest knowing your risk of zero is high.
Some Other Thoughts:
REITs Are Not Bonds. You own an equity interest in a fund that owns real estate. When the economy suffers, real estate can suffer. Many investors suffered a painful lesson about that during this month. I am one of those investors, although I am afforded a longer investment outlook than most as long as I’m not selling down shares. If you plan on liquidating the principal balance and not just relying on distributions, REITs may not be for you.
Mark To Market Losses: March of 2020 provided a tough lesson on the pains of daily mark to market reporting. Every minute you can log in and see what an investor will pay for any marketable asset. This had a painful psychological impact for fixed income investors in REITs and any investor holding assets other than US Treasury Bonds. In a panic, people only want cash or treasury bonds. Everything else will be marked to the most recent price someone was willing to pay in a market with limited buyers.*
REIT Dividend Tax Treatment: It is best to hold REITs inside a retirement account. The dividends have some complicated tax treatment (that fortunately tax software makes easy), but some portion of the dividends are often non-qualified and subject to your highest rate in a regular account. Choose where to place these positions appropriately.
REITs Can’t Retain Earnings: To qualify for no corporate income tax, the REITs must pay 90% of its earnings to shareholders. This means they can’t just stop distributions to retain capital when times get bad or asset prices look more attractive, the company must either issue new shares or sell assets to raise capital. Both are destructive to shareholders and part of why I advocate picking individual REITs. Look at their balance sheet and determine how much cash and available credit hey have. What are the future debt maturities? Beware that the overall returns shown in REITs will suffer from survivorship basis, the companies that don’t go to zero are the only ones who report cumulative earnings. (This is the same criticism of the Dividend Aristocrat strategy)
Do Your Due Diligence: Real estate is still real estate. You must be disciplined when purchasing in the same way you would when purchasing a physical property. What do they invest in? Who are their tenants? How much debt do they use and when does it mature? When do their leases mature? Do they have any tenant concentrations? What price are you willing to pay per share for this REIT?
How To Find REITs? If you are still interested in investing in REITs, the best directory I’ve seen is within the industry association, NAREIT. This is a good start to finding all of the REITs, just beware of the rosy information posted on this site since it represents the industry’s professional association. Then research the investor relations sections of the company websites and keep the same level of skepticism up when you are are looking at the company presentations (surprise, they’re all positive!)
Real Estate Investment Trusts still make up a portion of our portfolio and we are relying on them to come through for us in these tough times. I choose to invest in individual REITs and if you are willing to put in the work, it may be time to look at the asset class and decide if any are right for you.
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* Howard Marks published a March 2020 update titled Flattening The Curve, where he articulated mark to market losses and investing in uncertain times: “The more you want to garner potential gains and don’t mind mark-to-market losses, the more you should invest here. On the other hand, the more you care about protecting against interim markdowns and are able to live with missing opportunities for profit, the less you should invest.”