There exists lots of different and valid REIT investment strategies. Some investors look for abnormal yields and low FFO/AFFO multiples; others seek high discounts to NAV and others look for high growth potential.
No matter what strategy you implement, it is worthwhile to listen and understand the advices from Green Street Advisors, one of the world’s leading REIT research firms. It is famous for its NAV based pricing model and its very successful performance track record.
Green Street’s BUY recommendations have generated annualized total returns of 24% from 1993 to 2016 compared to 12% for the stocks in their coverage universe and 1% for their SELL recommendations. I have went through their website and other public material and here are my 3 main take-aways:
1. Favor Low Leverage
This goes against the ideas of many real estate investors who have always thought that the best way to get rich was to use other people’s money. Using cheap debt certainly can lead to higher returns during periods of economic expansion, but unfortunately the good times never last forever. Real estate is very cyclical and once the recession hit, the at first seemingly cheap debt becomes very expensive and can cause massive losses.
What is the solution for highly levered REITs when their balance sheet suddenly deteriorates during a recession? They start selling shares at cheap prices which significantly dilutes values when real estate recovers. If today, you believe that we are approaching a new recession, you better allocate your portfolio towards more conservatively financed REITs.
According to the latest REITWatch report from NAREIT, the average debt ratio of US Equity REIT stands currently at 31%. I personally take a very hard look when considering investing in any REIT with a debt ratio over 50% and will demand a higher risk premium in the form of a discount to NAV.
Yes, REITs with conservative balance sheets tend to trade at higher valuations, but this is well deserved when looking back at their track record. They are less volatile, deliver more predictable returns, have access to cheaper capital, are much more liquid during recessions and less likely to cut their dividends.
It has even been argued that debt does not create any shareholder value for REIT investors over time. The Modigliani-Miller theory states that leverage accelerates earnings growth, but since investors then perceive more risk, the value of the income stream is discounted to a lower multiple and the stock price end up being the same as without the debt. Debt is totally neutral from a return perspective but adds risk.
Even though property prices have risen more than 50% from 2002 to 2012, REITs that have employed less leverage have delivered far better returns over that time period than REITs with higher leverage. Green Street Advisors
One of the main reasons for this underperformance is that REITs with highly leveraged balance sheets tend to miss the opportunity to acquire assets at deeply discounted prices during times of deflation such as in 2008. Going into a recession, these REITs do not possess the financial flexibility to take advantage of opportunistic acquisitions and might even have to become net sellers during inopportune times to access liquidity.
2. Focus on Conflicts of Interest
While it is clear for everyone that good management is important, the degree of this remains often underestimated. According to Green Street Advisors, the most important drivers of GAV premium is franchise value and GA. Franchise value is an estimate of the relative value that the management is expected to add or subtract in the coming years. It is crucial for the REIT to be professionally managed by a team that focus on creating value for the shareholders, and not for themselves. Conflicts of interests are real and can significantly affect the future value of your REIT investment.
Externally managed REITs are typically cheaper than internally managed REITs (Ceteris Paribus) and their higher yields are often very tempting. You have to however keep in mind that this relative discount is often deserved and a result of high GA cost as well as higher conflicts of interests. The advisor earns a fee on all assets that it manages and is hence incentivizes to maximize the size of the portfolio often at the expense of the performance of those assets. They are therefore also more likely to for instance issue dilutive secondary offerings to increase assets under management. The advisor might also earn a fee on all new acquisitions, developments or dispositions causing more frequent trading and higher transaction costs.
I am not saying that all externally managed REITs are bad per se. There are good reasons for a certain REIT to be externally managed. Depending on the size of the REIT, an external manager will have better resources than the individual REIT and simplify operations. However, it must remain clear that at the end of the day, the external manager is running an asset management business and his interest will often not be the same as yours. His goal will be to maximize fee income which goes directly against your interest.
Except if the external management has undertaken substantial measures to align interest and improve corporate governance, I would pass on. Despite their lower prices relative to NAV, published research from Green Street Advisors has shown that the average total return of externally managed REITs typically lag the industry. They are often just not worth the risk.
3. Bigger is Typically Better (Ceteris Paribus)
One of the main purposes of REITs is to allow investors to participate in the returns of properties in a cost-efficient manner. Here size plays a big role. Large REITs are able to allocate their GA expenses over a larger pool of assets and minimize their impact on total returns. Smaller REITs suffer here from a competitive disadvantage as they do not possess the same economies of scale.
Source: Green Street Advisors
It could also be argued that larger companies have greater access different resources and have stronger bargaining positions with their suppliers and can obtain price concessions. All else being equal, larger size reduces for instance the cost of capital – both equity and debt. The larger size also gives the REIT stronger bargaining power with tenants and allows them to offer a wider array of services – increasing tenant satisfaction and retention.
Due to these reasons, large REITs should be favored relative to small REITs if the price was to be identical.
In my opinion, any REIT can become attractive at a certain price. Despite a highly levered balance sheet and poor corporate governance, a REIT could deserve a BUY recommendation as long as the discount to NAV is representative of these issues.
I prefer investing in high quality REITs, but also find myself investing in certain REITs that are externally managed, small caps and/or have higher leverage than average.
Lastly, it is important to keep in mind that a large discount to NAV and a high yield alone do not constitute a recipe for investment success. REITs managed by good management teams and trading at par or a premium to NAV will often achieve stronger long term returns than others trading at discounts but poorly managed. It is important to find a balance between price and quality.
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Disclosure: This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer. Readers are expected to conduct their own due diligence or seek advice from a qualified professional.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.