Back To Class: REITs 101

In our May 11th post, GDP Now Q2 Estimate At -34.90 Percent, So What Now? we mentioned our discovery of an incredible stock picker with a portfolio that has significantly outperformed the S&P in an upmarket and even during the crash.  She has been a friend of GMM for years but we never knew she had such a Midas Touch.  We hope to reveal some those picks sometime soon.

She saw our last post, COTD: The REIT Beat, and schooled us about the REIT sector in the following paper.  We think global macro 24/7 and individual stock picking is relatively foreign to us.  We view the REIT sector as a good long-term inflation hedge, which we worry about more than most during this time of massive deficit and debt monetization, and rarely do we get down into the micro weeds.

We learned so much about the REIT sector with her paper and picked up some good single REIT trade ideas. It is a must-read, folks.

By the way, we now call her Coach K, which she rejects and pushes back, “I am not a Duke fan!”

Ready to be schooled? Read on.

The REIT Sector

 

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Source: Reitsmarket

A real estate investment trust (“REIT”) is a company that owns, operates or finances income-producing real estate. REITs provide all investors the chance to own valuable real estate, present the opportunity to access dividend-based income and total returns, and help communities grow, thrive, and revitalize.

REITs allow anyone to invest in portfolios of real estate assets the same way they invest in other industries – through the purchase of individual company stock or through a mutual fund or exchange traded fund (ETF). The stockholders of a REIT earn a share of the income produced through real estate investment – without actually having to go out and buy, manage or finance property. Approximately 87 million Americans invest in REIT stocks through their 401(k) and other investment funds. – reit.com

By Carol K 

REIT basics:

The preferred metrics for evaluating REITs are Funds From Operations
(FFO) and Adjusted Funds From Operations (AFFO). Please, do
not use the P/E ratio to evaluate a potential REIT investment and do not embarrass yourself arguing with others in an investment forum that a certain REIT is not a “buy” because the P/E is indicative of overvaluation a strong buy because the
P/E ratio is so low.  Just don’t!

Adjusted Funds From Operations

REITs are required by law to pass 90% of their Adjusted Funds From Operations (AFFO) on to shareholders in the form of dividends.  REIT divvies are taxed as ordinary
income.

Leases

Know the type of lease a REIT’s business model is based on. In a regular
lease, the REIT collects rent on property and pays all expenses associated
with maintaining the property, such as maintenance, repairs, and property taxes.
With a triple net lease, the landlord collects the rent but the tenant
pays for all maintenance, property taxes, and other operating expenses. Many of the retail shopping center/strip malls, and stand-alone retail are configured as Triple Net
leases. These tend to be long-term (10-15 year) leases as well.

Credit 

Know the credit quality of REIT’s tenants. A REIT leasing to lower
quality tenants, for example, is clearly riskier and not as profitable, as turnover will likely be higher.

The internal management of a REIT is also critically important. Too
often in external management scenarios, there’s a conflict of interest
between the external management team of the properties and
the management of the REIT, the latter whose #1 priority is to look out for
its shareholders.

Now, onto specific sectors with some having their own sub-sectors.

Sectors

Data Center REITs

As the name implies, Data Center REITs own the properties with large, modern, super air-conditioned buildings that house floors of computer servers, storage, which power the cloud companies of all sizes.  I prefer established names, such as Digital Realty Trust (DLR),  Equinix (EQIX), and Cyrus One (CONE) that lease to the largest names in the S&P500.  My personal top pick is DLR, whose top 20 tenants are comprised of the American business elite.

Diversified REIT

Diversified REITs own a mix of various building types, typically in the office,
industrial, retail, and self-storage space. Prospective investors should
examine the concentration of tenant type and percentage of Average
Base Rent (ABR), which will determine both profits as well as the quality tenants.
Diversified REITs with multiple property types are more complex to evaluate, so it may be best to stick with household names with good diversification and a long-term success story, such as W.P. Carey (WPC).  W.P. Carey has a diversified portfolio and owns properties in major U.S. markets and also across Western Europe.

Industrial REITs

Industrial REITs generally own large warehouses and distribution centers (DC). Prologis (PLD) receives a lot of attention in the sector, but my personal fave is STAG Industrial (STAG).  STAG owns warehouses and distribution centers in secondary and tertiary markets across the United States, most located near major interstate highways for easy
access for large trucks. As e-commerce increases, warehouses and DCs in these markets will continue to grow at rates greater than in primary markets, such as NYC/LA/BayArea/CHI where land is less available and much more expensive.

Infrastructure REITs

Infrastructure REITs own the country’s pipelines, cell towers, fiber cables, utility transmission lines, cables, among other things. Cell tower REITs have done
very well for obvious reasons. The oil/gas pipelines are the most volatile and downright
dangerous, in my opinion, as many bankruptcies loom on the horizon in this subsector.

I find Hannon Armstrong (HASI) to be an interesting pick, which deals with realty investments in sustainable and green energy sources but has been severely challenged lately.

My faves are Cell Tower REITs, including American Tower (AMT) and Crown Castle International (CCI).  Don’t be mislead by the moniker, AMT has overseas holdings while CCI is currently based solely in the United States.  One advantage of CCI is that it is better positioned to capitalize on the small-cell towers associated with the rollout of 5G in the upcoming years.

Healthcare REITs

A lot of ground to cover in this sector with several subsectors.  I’ll try to keep it short and sweet.

Diversified Healthcare

These REITs dabble in multiple areas, and for that reason,  I don’t think it is a good time to take positions in  Ventas (VTR), Welltower (WELL), or National Healthcare Investors ($NHI).  In fact, it is possible there may never be a good time to do so.

Medical Office Buildings (MOBs)

MOBs include doctors, dentists, and medical imaging offices and labs.  A top quality pick and personal holding is Healthcare Trust of America (HTA).  Physicians Realty Trust (DOC) is compelling, and even more undervalued than HTA at its current price.

MOBs should be one of the safest REIT sub-sectors going forward, in my opinion.

Hospital REITs

Hospital REITs own the building and land but, not the underlying and day-to-day business of hospitals.

The only pure-play owning solely hospital buildings and ambulatory surgical centers is Medical Properties Trust (MPW), which I hold a position in.  MPW operates as a triple net lease operator, where tenants are responsible for maintenance and property
taxes. MPW has properties in the U.S., the United Kingdom, Germany, Spain, Switzerland, and Australia.

Assuming elective surgeries in the U.S. start to resume in the next couple of months, MPW tenants should again be in good financial shape. I believe the short-term COVID headwinds are reflected in the current share price.

Senior Housing REITs

Not to be confused with nursing homes, which provide skilled nursing care (see below). Senior Housing REITs include upscale apartment-style living for well-financed seniors.
Recall the Joan Lundon commercial aPlaceForMom.com?

Generally, high-end, I see them underperforming until the COVID crisis passes. Moreover, it is questionable if seniors will continue to able to afford this level of luxury living in the coming years.  Will seniors remain comfortable living in such close dense quarters post-COVI?  Another headwind is the trend of more seniors choosing to age in place in their long time homes with familiar surroundings and hire the home health aide to provide any needed care.  The availability of grocery delivery and other essential items will likely hasten this trend, in my opinion.

Skilled Nursing Facilities (SNFs )

I would avoid SNFs because Medicare/Medicaid reimbursement rates leave operators exposed to cash flow problems, including the inability to pay rent often leading to bankruptcy. Many SNFs have problems hiring and retaining adequate numbers of qualified workers to staff their facilities. Though a good concept, SNFs, unfortunately, have difficulty maintaining profitability under our current system, even in Canada, for that matter.

Life Science REITS

Life science building REITs are absolute gems, in my opinion. The only REIT solely
focused on Life Sciences is Alexandria Real Estate (ARE). ARE’s buildings are located on or near major campuses of the nation’s largest hospitals, medical schools, and healthcare/life science research facilities, including the Mayo Clinic, Duke Medical Center, Baylor Healthcare, and Harvard.

Lodging REITs

These REITS own hotels and resorts, which lease to major chains, such as Hilton, Hyatt, Marriott, and even Ritz Carlton, among the many players in this space. Lodging REITs tend to specialize in a particular type of lodging —  full service, select service, and premium hotels and resorts, and economy/budget class lodging services.

I am having difficulty finding a single attractive name in this space currently.  I
wasn’t invested in the sector prior to the COVID crisis but many investors still like
the space due to its above-average dividends, which are more certain better
economic times.

Mortgage REITs

This is one sector I profess ignorance, particularly with respect to quality and valuation,  as they differ from traditional equity REITs.  It includes commercial mortgage REITs, which hold mortgages on commercial real estate (RE).  There are some hybrid
residential and commercial mortgage REITs,  which is beyond my scope and interest.

Office REITs

Thes REITs consist mainly of office buildings and office parks. You can “stick a fork in ‘em,” in my opinion.   There are a few high-quality names and locations in the space, but they are not worth the risk.  Investors can find higher quality with less uncertainty and dependable dividend-payers elsewhere.

Residential REITs

There are two basic subsectors in this space.

Apartment REITs.

There are many players, variances in quality of housing (Class A, B, C properties) and geographies served in Apartment REITs.   Essex Property Trust (ESS) invests in higher-quality apartments and high-rises throughout Western U.S, coastal cities.

Mid-America Apartment Communities (MAA) invests in middle to upper-grade properties across the Southeast.  The analysis of the many other players in this space, the central focus should always be on the quality of properties owned, management, and the average percentage of rent collected and vacancies.

Residential Single-Family Home REITs

I do not invest in these REITs out of principle as many of their acquisitions come at the expense of folks losing their homes to foreclosure.  These REITs, many owned by
Wall Street private equity firms, who often swoop in like vultures to buy these homes at rock bottom prices, invest a minimal amount in cosmetic improvements.   Some are notorious for their poor customer service for their tenants, who number in the tens of thousands.  I can’t think of a single redeeming quality of this sub-sector as it currently
operates.

Retail REITs

Retail can be subdivided into malls, shopping centers, and stand-alone big-box retailers.

I do not believe malls are dead but just they are no longer prudent investments. This is the case for even the highest quality malls owned by Simon Property Group (SPG) or Taubman Centers (TCO).

I believe shopping centers are a better bet, especially the grocery-anchored
neighborhood shopping centers.  There are many to choose from in this space, including
Dividend King Federal Realty Trust (FRT), Kimco Realty (KIM), Brixmor Property Group (BRX), Regency Centers (REG) just to name a few of my faves in the space.

I wouldn’t consider a shopping center REIT unless it is focused on defensive businesses. Grocery-anchored or high quality, investment-grade big-box power centers, including strong household names, such as Home Depot or Lowe’s, which are more likely to survive both the COVID crisis and are more immune to e-commerce.

The only pick in the space I currently hold is Kimco (KIM), which is gradually moving the portfolio toward higher quality and better-located properties. Pentagon Centre, a multi-phase mixed-use development project located near The Pentagon in Arlington, Virginia is one of Kimco’s Signature Series developments. The adjacent area is home to many defense contractors and the new Amazon HQ-II site. These are mixed-use properties – housing, shopping, restaurants, and service-oriented businesses.

The Signature Series is a Kimco initiative designed to “move the needle”, pushing Kimco’s portfolio into higher-quality properties in core U.S. metropolitan areas. Examples of
other Kimco developments are Dania Pointe in Dania Beach FL, Lincoln Square in Center City Philadelphia, and The Boulevard on New York’s Staten Island.

Triple Net Retail REITs

TPN operates mostly in the single-tenant retail space. The best name in the space, bar none, is Realty Income (O).  Their trademarked motto is “The Monthly Dividend Company”.  Tenants are investment grade and on long term (10-15 years) leases.

Beware many names in this space have suspended or cut dividends for the time being with the exception of the Dividend King, FRT, and Dividend Aristocrat, O.  I seriously doubt either’s dividend is at risk, as both have fortress balance sheets and report higher than normal rent receipts for April and thus far in May.

Specifically, Realty Income CEO Sumit Roy told listeners on his recent earnings conference call the company received 83% of rents due from all tenants, with 100% full and total payment of rent from their investment-grade tenants.  O has an A-credit rating from S&P.  Proof again,  that quality matters.

Specialty REITs

These REITs include anything that doesn’t fit into another category but structured, primarily for tax purposes as a REIT, including, movie theaters and entertainment, gaming and casinos, and schools and daycare centers.

I don’t have a specific pick at this time, but if COVID were to magically disappear or
when a vaccine is made available to the wider public sometime soon, I like Vici Properties (VICI), a gaming and casino REIT.   Potential investors in the Entertainment and Recreational REIT space, such as EPR Properties (EPR), are strongly advised to look closely “under the hood” of these REITs.  It is important to analyze the portion of rent coming from riskier assets in a COVID world, such as movie theaters, dine-in restaurants, and indoor recreational assets, including golf simulators, bowling alleys.  These will likely continue to struggle with fewer customers in the coming months and will need rent deferments if they are to survive.

Timberland/Farming REITs

Timberland REITs own forested land and sell the timber to industries, such as paper mills, furniture factories, home builders, land lumberyards.

Farming REITs own the land that many large corporate farms lease to grow their crops. These REITs own the land and do not assume responsibility for the crops.  Because most tenants are larger food processing corporations, rent receipts are relatively more stable and predictable.  Big names, include Weyhouser (WY), CatchMark Timber (CTT), Gladstone Land (LAND), and Farmland Partners (FPI).

The information in this post represents our own personal opinions and are not investment recommendations.  We may or may not hold positions or other interests in securities mentioned in the post or have acted upon what has been written.  

All information posted is believed to be reliable and has been obtained from public sources believed to be reliable. We make no representation as to the accuracy or completeness of such information.

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