Real Estate Sector Ideas

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>>> 3 'Must-Know' Dangers Of REITs


Seeking Alpha

May 19, 2020

by Jussi Askola


https://seekingalpha.com/article/4347678-3-must-know-dangers-of-reits


REITs are very opportunistic right now, but risks also are on the rise.

Conflicts of interest, over-leverage and shaky fundamentals are the leading reasons for poor investment results.

We discuss how to identify red flags to avoid stepping on landmines.

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After the recent market collapse, the REIT sector has become very opportunistic. Many companies are now priced at similar valuations as in 2008-2009 and offer generational buying opportunities for investors who know what they are doing.

REITs that commonly trade at 3%-4% dividend yields now pay 8%-12% and offer 100-200% upside in a future recovery.

With that said, risks also are on the rise and you need to be more selective than ever before. There exist ~200 REITs but only ~50 of them are worth buying, and just half of that, has passed our due diligence at High Yield Landlord:

Before you buy shares of a REIT, you should know all the dangers that could derail your investment. Investors commonly think of REITs as a homogeneous market with great similarities from one name to another. In reality, this is a stock picker's market with enormous disparities in market performance between even the closest peers. Consider the following example:

Plymouth (PLYM) and Prologis (PLD) are both industrial REITs. If you had invested in PLD, you would have earned a nice return over the past years. However, if you had picked PLYM instead, you would have earned nothing and be down quite significantly.

There are some real landmines out there and the REIT market can be very punishing to investors who do not perform good due diligence on the risk factors. Below we discuss three "must-know" dangers of REITs. Avoid those and you will save yourself a lot of headaches in the future.

Danger #1: External Management Agreement

The first thing that we analyze is the management team. We always ask ourselves:

How shareholder-friendly are they?

What are their motivations?

Do they have a competitive advantage?

If you cannot trust the management, then the rest of the story is meaningless. You don’t need to waste your time analyzing the portfolio, balance sheet and valuation if the management is conflicted.

Even when the shares appear to be dirt cheap, you should just stay away. A conflicted management always will find a way to steal from shareholders and underperform sooner or later.

How do you recognize a poorly managed REIT?

The easiest way to identify conflicts is to look at the management structure. Most importantly, REITs can be managed internally or externally:

The internal management structure is the favored option. In this case, the management team is hired as employees of the REIT and they receive a salary that's tied to some key performance metrics. If they don’t perform, they can be easily fired by the board of directors.

The external management structure is a source of much greater issues. In this case, the management is outsourced to an external company that receives fees for its services. The fee structure here creates conflicts because the managers will often be compensated for maximizing the size of the company and not for optimizing its performance. Moreover, the management agreement has a multi-year term which makes it very difficult to fire the manager in case of trouble.

Conflict of interest - NGO Financial Risk Management: Balancing ...

The manager then becomes more protective about its fees than anything else. As an example, Global Net Lease (GNL), an externally-managed REIT, recently adopted a poison pill to discourage a hostile takeover of the company. They claim that it's for the best interest of shareholders, when in reality, it's more in the interest of the manager who does not want to lose its fee income. Just take a look at its performance since the IPO. I'm not so sure that this management is in the shareholder’s best interest:

Other examples of externally managed REITs with significant conflicts of interest include: Office Properties Income (OPI), Service Properties Trust (SVC), Industrial Logistics Properties, and other RMR-managed entities (RMR). We would stay away from this type of REITs at all cost.

But exceptions exist. The management structure is a good first sign of potential conflicts, but it should not be a deal-breaker on its own.

As an example, NexPoint Residential (NXRT) is externally managed, and yet, it has a strong track record of shareholder-friendly management. The difference here is that the insider ownership is very high at 20% and the managers keep buying more shares on the open market. We are actually very bullish on this externally-managed REIT:

In conclusion, we would avoid 95% of externally-managed REITs. Most of them are poorly managed, and even despite trading at a deep discount to other REITs, they tend to underperform in the long run. Don’t let their high yield fool you. Most of them are not great opportunities.

Danger #2: Overleverage In Times Of Crisis

If there's anything to be learned from the 2008-2009 crisis, it's that a poorly-timed equity issuance can have disastrous long-term effects on the performance of a REIT.

Back then, many REITs were forced to issue equity at fire-sale prices because refinancing became impossible in the mid of the crisis. It was very dilutive and shareholders paid the price. You want to avoid this type of situation at all cost.

Today, the banking system is in much better shape and REIT balance sheets are stronger than ever before. However, there still exist some over-leveraged companies that are very close to violating debt covenants in this environment. Good examples today include the lower quality mall REITs: Washington Prime Group (WPG) and CBL & Associates Properties (CBL):

Both are priced for high risk of bankruptcy or a dilutive equity infusion in the near future. Malls were hit particularly hard by the recent crisis and the lower-quality properties will take longer to recover. Combine that with high leverage and you have a perfect mix for disaster.

Even if a REIT is very cheap, it does not mean that it will ever recover to former levels if it's forced to issue a ton of equity, diluting shareholders in the process. If you are going to invest in this type of overleveraged company, skip the common shares and go up the capital ladder.

As an example, Bluerock Residential Growth REIT (BRG) is an over-leveraged apartment REIT. The common shares are very risky and may suffer from the issuance of dilutive equity. However, its preferred shares (BRG.PD), are higher on the capital stack, offer good margin of safety, and yet, they trade at an 8.5% dividend yield and offer 20% upside to par. The risk to reward is stronger, in our opinion.

Danger #3: Deteriorating Long-Term Prospects

What's unique about this crisis is that people are forced to stay at home and avoid social contact. As a result, they are learning to work from home, shop online, and entertain themselves in new ways.

Retail, hospitality, and office property sectors are the most affected by this crisis and you need to be especially selective when investing in these REITs.

In the long run, we believe that the office sector is set to lose the most. Employers are noticing that they could save money on their office rent and that some employees may be even more productive at home.

With that said, not all office properties are created equal. As an example, a Class A skyscraper in the middle of Manhattan is probably better positioned than a class B low rise office building in a more rural area.

Companies lease space in urban skyscrapers not because they have to, but because it's valuable to their image when they bring clients to a prestigious property. Law, consulting, and investment firms won’t suddenly leave these properties. The demand is high and the supply is very restricted due to the location. Therefore, a company like SL Green (SLG) that specializes in trophy office properties is likely to do fairly well in the long run.

On the other hand, a lower-quality office REIT like City Office (CIO) is likely to suffer much more from decreasing demand and oversupply. The properties do not have the same location and prestige advantage to protect them. In fact, CIO already slashed its dividend by 36% and the impact of oversupply could be felt for many years to come.

Bottom Line

Most REITs are very cheap today, but not all of them are worth buying. You need to become very selective in this market to sort out of the worthwhile from the wobbly.

Most importantly, you should learn to identify REITs with (1) conflicted management teams, (2) over-leveraged balance sheets and (3) struggling assets. These are the three "must-know" dangers of REIT investing in 2020.

In every crisis, there are losers and winners. Astute investors made fortunes in 2008-2009 as REITs nearly tripled in the recovery:

Today is no different. We are again hit by serious crisis and opportunities are abundant. We believe that those investors who play their cards right are set for exceptional returns in the coming years.

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