REITs — A Look Under the Hood

Join Chris Perras for the 4/17/2020 edition of Stock Talk!

Chris Perras: Good morning. I’m Chris Perras, Chief Investment Officer at Oak Harvest Financial Group in Houston, Texas. Welcome to our weekly Stock Talk podcast: Keeping You Connected to Your Money.

I’m going to digress this week from the constant market commentary of the current virus outbreak and its effects on the markets and the economy. Today, instead, I’m going to provide what I hope is an eye-opening educational lesson for investors in REITs, or real estate investment trusts. I’m doing this largely because these investment vehicles have become a huge investment category the last 10 years, as baby boomers have desired investment vehicles that provide income. With government interest rates at historic lows, money has flocked into real estate, mutual funds, single stocks, and ETFs.

Public REITs account for almost $2 trillion in assets. Private REITs account for almost $1 trillion. Combined, this $3-trillion industry has become huge. This asset class, that most of my comments here are directed specifically at, are publicly traded single stock listed REITs.

First off, what is the definition of a REIT, a real estate investment trust? Here’s the definition, and please listen carefully. They are companies that own, or, and this is very key to today’s story, they either own, or they finance income-producing real estate across a single or multiple property sectors. REITs allow investors to invest in a portfolio of otherwise illiquid real estate assets the same way one can invest in other industries through buying stocks, mutual funds or ETFs. The stockholders of a REIT earn a share of the property income produced from the real estate investment without having to personally go out and buy, manage, or finance a property. That sounds simple enough, doesn’t it?

REITs invest in a wide scope of real estate property types, including apartments, offices, warehouses, health facilities, data centers, the big cell phone towers off the highways, hotels, retail stores, and infrastructure. They can be single property focused, like Crown Castle Holdings that’s publicly traded, which focuses on cell phone towers, or they can be diverse in their holdings, like a W.P. Carey that owns apartments and offices and all sorts of multi property types.

Most REITs operate along a very straightforward business model. They directly own real estate. They lease space to clients who pay rent for their use. What makes the REIT structure so special? The REIT company generates income, which is not taxed at the corporate level, and which is then paid out to shareholders in the form of dividends. Shareholders then pay taxes on the dividends they receive. REITs have the luxury, through their structure, of avoiding the double taxation issue that most corporations run into when they pay shareholders dividends.

Double taxation is when a corporation must pay tax on its earnings, then they distribute cash to its shareholders in the form of dividends, which are then taxed again at the individual level. The catch here is that a REIT must pay out at least 90% of their taxable income to their shareholders. In fact, most of them payout near 100% of their income. This does not leave REITs much room for flexibility, and almost no room for stock buybacks. Most REITs only grow by way of selling additional shares to shareholders or debt offerings.

What are the different types of REITs? There are four types of REITs out there. The team at Oak Harvest invests in only the first type. That type is equity REITs. This is category one, equity REITs. The majority of REITs that are publicly traded are equity REITs. These REITs own and or operate income-producing properties. These types of REITs usually leverage or borrow money to enhance shareholder returns up to no more than 25% to 35% of their capital. If you’re going to borrow money, that’s very low leverage. These REITs normally yield 2.5% to 7% to their shareholders, with the sweet spot being a 4.5% to 6% dividend yield. Publicly traded examples of this structure, as I mentioned previously, are Crown Castle and W.P. Carey.

Why do investors venture out of category one to invest in REITs? Most of these investors are in search of higher income streams. However, most investors do not realize the oversized risk that they’re taking to do this.

Category two in REITs, the mortgage REITs. These REITs, in my opinion, are not REITs outside of tax structure. These REITs provide financing for income-producing real estate by purchasing or originating mortgages and mortgage-backed securities, and then earning income from the interest on these investments.

I’m going to rephrase that to our listeners. Ready? Sit down. These REITs don’t own real estate. I repeat, these REITs don’t own real estate. They own paper. These REITs on bonds or mortgage-backed securities that back the real estate, or are used to construct the real estate. These REITs are usually a group of portfolio managers, traders, and analysts sitting in an office, analyzing mortgage bonds, and buying and selling bonds. These structures usually leverage their portfolios, ready, sit down, 350% to 600%, with the average being 450%. By doing this, these REITs can take a very small spread of about 2% lending spread, and make an investor drool over a 9% to 12% yield during calm market times.

Unfortunately, during times of stress, like the last two months, the ultra-high leverage and borrowing needs of these REITs make these the last place an investor wants to be. Falling interest rates and higher interest rate volatility, like we’ve had over the last three months, can accelerate mortgage refinancing, causing these portfolios huge investment risk. These factors can cause massive shifts in the terminal value of these holdings.

We’ve seen all of this the past three months. Mortgage REITs, like Redwood Trust, which was my first learning experience in this category over 20 years ago, have fallen by over 80% in three months. As enticingly high an 8.5% to 12% yield was in January, it has now become 40%. Other high-leveraged model mortgage REITs include Apollo Commercial Real Estate, Two Harbors, and MFA Financial. The team at Oak Harvest sold any of these types of vehicles out of our portfolios 18 months ago, as we were concerned about people stretching for yield.

The final two categories of REITs, which I believe are equally as toxic, are public non-listed REITs, these are also known as untraded REITs, which came flooding to the market around 2015, 2016, when interest rates first collapsed to very low-levels, and private REITs, which are private offerings that are exempt from SEC registration. Both categories of REITs normally entice investors with their advertising of 10% to 15% yields. Both categories have proven to be too good to be true over time.

The two major things I want listeners to take away from this podcast. First, all REITs aren’t created equal. It’s become a very generic term, much as the term hedge fund has become generic. Secondly, before you stretch to buy any stock, including REITs, that has a high enticing yield, please check under the hood, why is the company paying what looks like an oversized dividend? Is it sustainable? What is this company saying? Is this a warning? Equity investment is about total return. It’s not just about dividend income percentage. Dividends are not guaranteed. A high-paying dividend does you no good if the stock depreciates in value every year. It does you no good if the stock has a history of big one-time collapses that wipe out multiple years of dividend income in a mere weeks or months.

At Oak Harvest, we are comprehensive long-term financial planners. What this means is that our client, you and your financial advisors, should have a financial plan that is independent of volatility in stock markets. If you’re retired or in the process of retiring, give us a call at 281-822-1350. We are here to help you plan your financial future, help smooth the financial path you have into and through your retirement years with a customized retirement planning. Thank you and have a great weekend. This is Chris Perras at Oak Harvest.

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