REITs are favorites among dividend investors. But there is a fallacy that real estate as an asset class outperforms stocks in general. That is not true.
You can see that at no point in the past five years has real estate outperformed large-cap stocks in general or the Nasdaq 100 in particular. In fact, only about half of REITs had a positive total return the past five years.
Here is going back to the bottom day of the financial crisis.
Again, you see that the newer economy Nasdaq outperformed and that the broad large-cap stock market and REITs were neck and neck.
This should point out two things to you:
First: asset allocation matters.
Second: security selection matters.
In breaking down real estate investments, one thing that we notice that real estate services firms, particularly tech-based, outperformed REITs in most cases. The lesson here is that while real estate is often a great investment at the individual level, that REITs might not be the perfect investment account counterpart in all situations. Often, it is the asset light software as a service companies that service REITs and real estate winners that end up the big winners.
Types Of REITs
There are multiple types of REITs. Investing in the right sub-sector at the right time is a large part of building an asset allocation. Here are the general equity REIT categories as described by NAREIT. Here are the equity REIT categories:
- Health Care
- Data Center
Not only are these REITs available in the U.S., but there are also some international companies that can provide both real estate diversification and foreign diversification.
A non-equity flavor is also available: Mortgage REITs. Again, from NARIET:
"Mortgage REITs (mREITS) provide financing for income-producing real estate by purchasing or originating mortgages and mortgage-backed securities (MBS) and earning income from the interest on these investments.
mREITs help provide essential liquidity for the real estate market. mREITs invest in residential and commercial mortgages, as well as residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS). mREITs typically focus on either the residential or commercial mortgage markets, although some invest in both RMBS and CMBS."
A key component of mREITs is leverage. That is, most mREITs apply leverage to a portfolio in order to create greater income. This has a positive impact in good markets, but can cause a crushing blow in bad markets. In my opinion, mREITs should only be bought after crashes when the government or Federal Reserve is providing support for mortgages, and most of the damage has already been done.
Broad REIT Investment Thesis
Because, as a group, REITs do NOT outperform stocks, we should look at REITs as a way to diversify first and generate income second.
We must also keep in mind our Investment Philosophy that we only want to invest in individual securities that can far outperform the stock market. What is the point of single security risk otherwise?
So, that means the REITs we want need to have tremendous value against assets or growth - or both. There are not many that fit that bill.
There are many zombies in REITs, and many of those will cut dividends at some point and possibly dilute. It is imperative that we are very selective in buying REITs.
Three Dangerous REIT Classes
We want to be very careful with Office REITs, Mall REITs, and Hotels.
Office buildings, particularly that own taller buildings, and malls need major remodeling in the coming years. The problem for office buildings is that, due to plumbing and ventilation, it is difficult to convert to residential to make mixed use.
Mall REITs face two major problems:
- a need for major capex spending to create mixed environments.
- lower future rents from a lower retail (high rent) mix.
That is a double whammy that will take years to work through.
Of course, both office buildings and malls have a residual value in the land even if the buildings are not that valuable. As investors, if we can identify going concerns that get close to residual value in their stock price, then those can be extremely good investments, that is, companies priced for bankruptcy that won't go bankrupt, are generally good deals.
Hotels face the same kind of pressure that retail malls have from Amazon (NASDAQ:AMZN). The Airbnb effect is going to be substantial. Many mid-range hotels are in big trouble. Certainly, motels have a role at the low-end, and people will pay for luxury, but the middle, I see major disruption and expenses to adapt to that disruption.
I would caution against buying the favorites of yield chasers. Again, I advise looking at the spreadsheet at the 2-year and 5-year total returns.
Big Upside REIT Classes
At this particular moment in history, there are also a lot of REITs so beaten up that they could double or more in value in the next 5-10 years on top of the income generation. Many could yield triples or better in total return this decade.
Most REIT investors are drawn to yield. However, without underlying growth and financial strength, we know that dividends get cut in every recession. We have seen that recently. Focus on quality over yield.
In the spreadsheet I attached above, you will see that the best total returns were not from the highest yielders. Rather, the best returns were from REITs that offered some sort of growth.
Three types of REITS and 2 other real estate plays stand out to me:
- Industrial - as supply chains move due to machine learnings, industrial REITs will remain in high demand and be able to command higher rents, as well as, grow their footprints.
- Specialty - this is a wide berth and for screening purposes, often includes data centers, infrastructure, and other narrow categories.
- Retail Triple Net Lease ex-mall - easy to maintain, usually plenty of open air, easy to keep rented, often grocery-anchored, looks good going forward.
- Real Estate Development - not REITs proper, but as I have discussed, this is often where the big money is made. Pay attention to developers with good track records.
- Real Estate Services - technology-driven real estate services have been among the leaders for nearly a decade. They are starting to pay dividends too. Don't overlook these.
I'm neither bearish, nor bullish on residential REITs. Each one has to be considered on its own merits. I do believe the big rush into renting by the Millennials has ended, and they will drift towards single family homes. There will be some great opportunities in residential REITs based on location and style, but in general, I am neutral on the group.
There are, of course, many other opportunities than I outlined above, every REIT needs to be evaluated individually from the business level.
REITs In Your Asset Allocation
Remember, most folks have real estate via their home, so the common wisdom was not to add too much real estate exposure via REITs.
Based on the old 60/40 portfolio rules of 60% equity and 40% bonds, a balanced total return investor might have a middle single-digit percentage to a middle teen percentage of their assets in REITs. Think of it a lot like how we are thinking about gold the next several years.
Today, we live in an era of very low interest rates. As real estate and bonds are both interest rate sensitive, I am using real estate in place of a substantial portion of what would otherwise be bonds in a portfolio.
Risk is always higher with equities than fixed income, but I think that risk differential is higher today than normal. In addition, over the long term, REITs have more upside than fixed income.
So, just as I am using gold miners and gold for 8-16% of portfolios, I think a similar allocation to REITs makes sense. I can see REIT percentages for your asset allocation of 8-16%.
REITs, therefore, are part of your long-term investment portfolio. For most investors, your portfolio might look like this:
- 60-80% stocks
- 8-16% gold and gold miners
- 8-16% REITs
- Balance in cash and other assets.
Typically, growth investors might not hold that much in real estate. However, so much real estate is beat up now that it complements more growth-oriented investments well right now.
As REITs rise in value, growth investors will need to trim faster than balanced total return or retiree investors. Then again, by the time that happens, growth investors might be on the verge of retirement, in which case this allocation might hold subject to valuation and economics at the time.
Closing Investment Quick Thought
You want 5-10 REITs to build your own "REIT ETF." Dividend Sleuth and I have narrowed the list down to about two dozen REITs, as well as, several services and development companies.
A normal ETF weighting in our asset allocations is 3% (typically nation specific ETFs) to 24% (Invesco QQQ (QQQ) our preferred large cap index). We expect that most dividend investors will want a REIT allocation. Growth investors may favor the real estate services and development companies. Our portfolio models reflect 8-16% in real estate linked investments.
As we build this sleeve of our asset allocation, I want to remind you to focus on quality first. There is risk in REITs despite the underlying real estate value. Debt can crush any business that loses revenues.
After two decades of studying this space and spending the past two years diving into the underlying assets, contracts and economics of over 100 companies, I have one simple conclusion: Well over half of the listed REITs have significant problems to deal with this decade. Many will cut dividends. Some will merge sideways with no real benefit to shareholders. Some will get bought cheap. A handful will fail outright.
As always, we do our best to manage risk first.