Most REIT investors have a backward strategy that leads to lower returns.
They will invest after asking one, maybe two questions:
- What is the dividend yield?
- What is the ticker symbol?
Ok, I’m simplifying a bit, but you get the point. REIT investors are a yield obsessed bunch. I love cash flow investing as much as the next investor, but over focusing on yield is a great way to lose your shirt. Sure, it might prove effective over the short term, but this strategy falls apart if the underlying real estate story isn’t stellar.
Buying a REIT solely off its dividend yield is like buying wine solely off its price. Sometimes it works out, but most times you get fleeced.
I’m looking for REITs that can compound for decades. A high dividend yield today is meaningless to me if the REITs strategy over a 20+ year time horizon is questionable.
Therefore, before I look at any REIT numbers, I ask the below questions.
High Level REIT Review Questions:
- Does this REIT own great real estate that I’d love to co-own?
- Do those properties compound wealth on their own (without a ton of ongoing capital)?
- Does the REIT have a strong pipeline of new acquisitions?
- Is the management team tenured and competent or is it a revolving door of bozos?
- Is management skilled at capital allocation? Do they raise equity or buyback shares at the appropriate time to fuel growth without overly diluting shareholders?
- Does the REIT’s sector (asset class) face structural demand problems?
If the answer to any of these questions is no, what’s the point of pouring over the numbers? Sure, you can make short-term profits on an undervalued REIT, but if doesn’t check the above boxes growth – and returns – are going to stall.
Each of the above questions is worth exploring, but for this article we’re going to focus on the last question: Does the REIT’s sector face structural demand problems? Why? Well I’m not sure if you heard, but there is this virus going around and it’s impacting tenant demand for multiple asset classes.
Below are my thoughts on the various real estate sectors, how they are handling the crisis and the long-term demand impacts of the virus, if any. The rent collection statistics were pulled from company filings and NAREIT surveys.
The Good:
Manufactured Housing
- Has handled the virus with flying colors. Large owners are reporting April & May collections of around 97%, which is unreal given the circumstances. Its early, but June collections look strong as well
- Transactions have slowed, but the private equity love fest continues. Plenty of new buyers hungry for scale.
- 100+ pad mobile home parks and portfolios in reasonable markets will continue to command top of market pricing as long as interest rates say near record lows
- Recession resistant: Occupancy and net operating income can still grow in recessions – we’re seeing the defensive nature of manufactured housing playing out in real time
- No long-term structural changes to the industry due to virus. Business as usual
Single Family Rentals (Bulk Owners)
- Above average collections (low 90% range) thus far. Near term collection concerns (once unemployment stimulus expires) due to job losses but this emerging asset class could benefit from crisis. There will be – at least temporarily – additional net migration away from dense cities that were hit hardest by the virus
- We didn’t overbuild homes this cycle – supply / demand story for large rentals is strong
- Freddie Mac research survey found that 84% of renters still believe renting is more affordable than owning, an all-time high for the survey
- Still difficult for the average American to qualify for a mortgage – lenders overcorrected from the credit crisis. This leads to more demand for rentals
- Millennials are still human beings....I think. As soon as that second / or third kid arrives, they too will want another room to escape the crazy – if only for a brief, but glorious ten minutes. Bye, bye Sunday brunch, hello Home Depot. Or perhaps I’m wrong and this is me justifying my life choices
Industrial
- Solid 94% collection the last two months
- Online shopping Tsunami counterbalances short term demand loss
- Some markets are definitely frothy and overbuilt, but growth should bail most owners that can hold long term
- Class A properties (cross dock, 25+ clear heights, in major distribution markets with direct access to major highway or railway infrastructure) feel defensive given the circumstances
The Pretty Good
Apartments
- Showing resilience with 94% rent collections, Class A (nicest assets) are outperforming
- Growing job markets with tight zoning laws are safe haven ports in the storm
- Buyer beware of markets where new construction has spiked – new development has finally outpaced demand in a number of major cities
- Underwriting projections (rent & occupancy) that looked modest two months are probably wildly aggressive today – expect lower near-term growth
Office
- Above average 92% collections. Office collections are less impacted by COVID due to longer term leases from credit tenants (this excludes those landlords that thought it was smart to lease half their building to WeWork).
- Long term – more problematic. A subset of companies will certainly downsize space or non-renew their leases. However, there are plenty of parents that once fantasied about working from home but are now taking conference calls from the car in the garage
- The vast majority of large firms are going to keep their headquarter offices. However, plenty of satellite offices will be on the chopping block
- In other words, the “death of office” calls from the cheap seats are exaggerated, but I still wouldn’t want to own a lot of highly leveraged office deals right now
Self Storage
- Solid 93% collections reported by the largest storage operators
- Self-storage has performed well in prior recessions
- Accounts receivable balances are up but so is occupancy
- Businesses and homes will be downsizing to save money – all that stuff needs to go somewhere (why that somewhere is not the dumpster is beyond me, but Americans love their junk).
- However, most 24-hour city / major markets are still overbuilt. There will be some distress opportunities (from builders that overleveraged late in the cycle)
The Ugly
Malls (Retail)
- April and May collections came it at a disastrous ~23%.
- Luxury malls and outdoor entertainment centers will recover. People don’t impulse buy as much online, they are much more likely to blow some cash after a couple salty margs at The Grove (insert your local trendy outdoor mall). Plus, if shelter in place has taught us anything, it’s that home is boring. The crowds will return
- However, the remaining small market, Sears / JC Penny anchored malls built in the 1980s are now on suicide watch
Strip Malls (Retail)
- Ouch. Do not pass go, do not collect $200
- April & May rent collections were between 20-50%
- High percentage of poorly located strip centers without a viable grocery store or stellar anchor (ex: Home Depot) are TOAST – many of these will be converted to alternative uses. Get ready for more trampoline parks!
Gaming (Casinos)
- Near perfect collections (as these companies rent land to major casino operators)
- Despite the spike on reopening weekend, the casinos will certainly suffer until therapeutic solution or vaccine arrives. However, last time I checked, gambling is still addictive and being the house is a legal way to steal
- The firms that make it to the other side will gobble up competitors and have a bright future
Hotels
- Woof. Going to be a rough 24 months. Triple whammy of virus reducing travel coupled with lower economic demand (recession) and too much supply
- The messy middle: top-tier hotels locations backed by big investors will survive. Budget road hotels should see occupancy gains soon as more families opt to fire up the van vs. crowded flights. But middle tier hotels in small markets???
- We’re all Zoom wizards now. Businesses will reduce travel budgets, but conferences will eventually return. For some strange reason Americans can’t get enough conferences
- Hotel Brands will matter more than ever. Temperature scanning, sanitation stickers everywhere, virus free wristbands. Traveling is about to get weird.
- However, well located hotels don’t have a structural problem (looking at you retail). Don’t get me wrong, plenty of small market, middle-tier hotels are going to zero – but Americans are not going to stop traveling permanently. Pretty sure my wife is still going to opt for the beach hotel over the RV.
If there is life, there is travel.
Bottom Line
I don’t suspect this is going to be another 2008 real estate crisis where every asset class tanks and / or suffers for years.It’s clear that a number of real estate sectors are essential and can hold their own in horrific economic climates.
Investors must tread carefully though. After the last real estate downturn, you could have picked almost any major REIT and done quite well. This is more of sharpshooter market. There are plenty of REITs that will struggle and should be avoided. Watch out for REITs with high yields with high leverage that are issuing new stock.
Yes, the future looks dim for most REITs in demand challenged sectors (retail / hotel). However, the best companies within a distressed sector will likely have the highest REIT returns over the short term. Reason being, they can leverage scale and giant balance sheets to scoop up competitors at basement pricing. We have too many retail buildings and hotels in this country, but supply is not going to zero.
Therefore, if you want to play in a sector facing longer-term demand issues, pick an elite REIT within that sector that is hungry to grow. Emphasis on growth because the underlying real estate (strip retail, malls, hotels) won’t bail investors out this time. Same store net operating income growth could be muted for years. The surviving REITs must focus on acquisitions to outperform.
Unless you’re a seasoned real estate investor, I do not recommend betting on most small cap retail or hotel REITs today. I suspect they’ll be playing defense for a while. These firms do not have the balance sheets to both survive this recession and capitalize on distressed acquisitions.
There are REIT deals to be found in both strong and challenged asset classes. If you decide to go treasure hunting via a distressed hotel or mall REIT, remember that screaming REIT deals (signaled by a huge dividend yield) are typically cheap for a reason.
