REITS-the Real deal about Real Estate Trusts
We first covered the topic of REIT investing, or real estate investment trusts, a little over two years ago, right after the March 2020 Covid market fall. Given our recent News or Noise video on “dividends matter,” I wanted to take this video as an opportunity to walk you through REIT investing and what you should and should not be looking for if you are out there picking your own stocks and searching for dividends.
I am Chris Perras with Oak Harvest Financial Group here in Houston, Texas, and welcome to our weekly stock talk podcast. Before we get into this week’s topic on “REIT Investing,” please take a moment to click on the subscribe button and click on that notification bell so you will be alerted when our team uploads our latest content.
Retirees and many others nearing retirement, love dividend stocks because they can help provide current reoccurring income through their cash distributions. Many investors gravitate toward owning some publicly-traded REITs or Real Estate Investment Trusts.
I’m going to provide what I hope is an eye-opening educational lesson for investors in REITs. I’m doing this mainly because these investment vehicles have become an enormous investment category in the last 20 years, as baby boomers have desired investment vehicles that provide income for retirement. With government interest rates low over the previous 15 years, money has flocked into real estate by way of mutual funds, single stocks, and ETFs.
Public REITs account for around $2.5 trillion in assets spread amongst over 225 public companies. Private REITs account for almost $1 trillion. Combined, this $3.5-trillion industry has become massive. The asset class that most of my comments here are directed specifically at is publicly traded, single stock, listed REITs.
First off, what is the definition of a REIT, or a real estate investment trust? Here’s the definition, and please listen carefully. They are companies that own, and this is very key to today’s story, 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 shareholder of a REIT earns a share of the property income, which is commonly referred to as funds from operations. The REIT structure opens the door to investing in real estate 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 variety of property types, including apartments, offices, warehouses, health facilities, data centers, and even the big cell phone towers you see off the highways, or hotels, retail stores, and infrastructure. They can be single property-focused, like Crown Castle Holdings, which is a publicly-traded cell tower REIT, or they can be diverse in their holdings, like a W.P. Carey, which owns apartments and offices and all sorts of multi-property types.
Most REITs operate on a very straightforward business model. They directly own physical 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. They then pay those funds out to shareholders in the form of dividends. Shareholders then pay taxes on the dividends they receive.
REITs have the luxury, through their tax 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 its taxable income to its shareholders. The fact is that most of them pay out nearly 100% of their income. Sounds great, yes? Most of the time. However, 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 first type is equity REITs. Most 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 typically yield 2.5% to 7% to their shareholders, depending on their organic growth rates. The sweet spot for yield seems to be a 4.5% to 6% dividend. 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. Instead of a low to mid-single-digit dividend, they are looking for 7%,8%, or even double digits. However, most investors do not realize the oversized risk that they’re taking doing this.
Category two of REITs are mortgage REITs. These REITs, in my opinion, are not REITs outside of their 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 and say it again. Ready? Sit down. These REITs don’t own physical real estate. I repeat, these REITs don’t own real estate. They own paper. They own IOU’s. These REITs own 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. There is no land, wood, copper, or steel involved in these REITs. It’s all paper to the investor.
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%, called a lending spread, and make an investor drool over a 7% to 12% yield during calm market times. This is the math for them. 2% yield x 350% to 600% leverage is a 7 to 12% dividend. Sounds great, yes?
Unfortunately, during times of stress, like the last three months, the ultra-high leverage and borrowing needs of these REITs make these the last place an investor wants to be. Rising interest rates and higher interest rate volatility, as we’ve had over the last three months, can cause these portfolios huge investment risk. These factors can cause massive shifts in the terminal value of these holdings.
We’ve seen all of this in 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 almost 50% this year. As enticingly high an 8.5% yield was in January, it has now become 12.5%, but you lost almost 50% of your initial investment. Other high-leveraged model mortgage REITs include Apollo Commercial Real Estate, Two Harbors, and MFA Financial. The team at Oak Harvest tries to avoid these investment vehicles.
The final two categories of REITs, which I believe can be equally as toxic, are public non-listed REITs and Private REITs. The First category, Public non-listed REITs are also known as untraded REITs, which came flooding to the market around 2015, 2016, when interest rates first collapsed to very low levels. The second category, private REITs, are private offerings that are exempt from SEC registration. Both categories of REITs normally -e investors with their advertising of 10% to 15% yields. Both categories have mostly proven to be too good to be true over time.
The two major things I want you to take away from this video. 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. Ask yourself these questions.
Why is the company paying what looks like an oversized dividend compared to everyone else in the same industry? Is it sustainable? What is this company saying? Is this a warning? Equity investing is about total return. It’s not just about a dividend income yield. Also, 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 mere weeks or months.
Our team here at Oak Harvest knows that 2022 has been a trying time for those in the equity and bond markets who are not trading oriented. Almost all financial markets, both stocks, and bonds have sustained higher volatility this year, unlike in recent years. This volatility is a harsh reminder to investors that stocks do not always go up. Remember, unlike the insurance markets and those tools, there are no guarantees in the public equity markets. We know these sharp market moves drive emotions and the urge to make changes to what are supposed to be longer-term asset allocations.
If the ongoing market volatility is making you feel uneasy, give us a call, and schedule a meeting with an Oak Harvest advisor. Our team does have insurance-based tools that do not have the volatility of public markets. However, we remind you, that these investments will also have lower long term expected returns for your savings and retirement.
At Oak harvest, we think our clients are best served by us helping them plan for their future needs, instead of focusing on the past. The future and stock markets are always uncertain and that is why our retirement planning teams plan for your retirement needs first, and your greed’s second.
Give us a call to speak to an advisor and let us help you craft a financial plan that helps you meet your retirement goals. Call us here at (877) 896-0040, and schedule an advisor consultation. We are here to help you on your financial journey into and through your retirement years.
CFA®, CLU®, ChFC®
Chief Investment Officer, Financial Advisor
Chris is a seasoned investment professional with over 25 years of experience working with some of the most successful money management firms in the world. Chris has made it a point in his career to adapt as the market landscape changes, seeking to utilize the appropriate investment strategy for a given market environment. His transition from managing billions of dollars at the institutional level to helping individuals and families retire is guided by a desire to see first-hand the impact he is making in the lives of clients at Oak Harvest.