REITs: The Other Kind of Real Estate Investments

Real estate investors typically see themselves as buyers of properties with the idea that they’ll either re-sell them for a profit or hold on to them in order to collect income. Actually, though there’s another way. One can invest by buying shares of publicly-traded Real Estate Investment Trusts (REITs). It can be well worth knowing about these, especially during times when the market in which you typically operate offers unsatisfactory opportunities.

 About REITs

A REIT is a trust that owns and operates real estate properties in order to generate income. Although legally referred to as a trust, for most practical purposes, you can think of it as a corporation. You, as a shareholder of the REIT, can buy and sell in the stock market exactly as you do with stocks and Exchange Traded Funds (ETFs). That means no showings, no open houses, no mortgage applications, no appraisals, no inspections, no down payments, no closings; just a few mouse clicks in any on-line broker account — which can be through a fancy firm like Charles Schwab or any one of a number of super low-cost firms like Trade King or FolioInvesting.com.

There is an important difference between one of these trusts and a corporation. Management of the latter can choose what to do with its cash flow. It can pay it to shareholders as dividends, or it can reinvest in the business (it’s existing business or completely new ventures). And, by the way, the cash flow it has is after corporate income taxes are paid. If some of that cash flow is paid to you as dividend, you also have to pay your own income tax on what you get. (Many scream and howl about this “double taxation” of dividends. Congress heard — a bit. Many such dividends are, at least, taxed at a lower rate, but they are still taxed.) A REIT has no choice but to pay substantially all of its cash flow to shareholders as dividends, and in the case of REITs, we’re talking about cash flow that has not been shrunk by payment of corporate-like taxes. There is only one tax bill here, the one you pay on the income you get. REIT shareholders don’t get the consolation-prize lower dividend tax rate, but they have more money to work with.

As with anything, there are pros and cons. REIT pros here involve liquidity (you can buy and sell with just a few mouse clicks), diversification (you can have your fingers in hundreds or more of properties), and peace (you are not the one getting calls  about broken pipes at 4 AM). The cons involve control: You’re delegating the decision-making to the mangers of the REIT. That means you have to figure out a way to decide if management of a particular REIT is doing a good job, and that is a challenge since in the public securities markets, what a typical realestate investor might consider ordinary due diligence is deemed, by the SEC, a felony (a for-real felony: Ask Martha Stewart about trading on “insider information.”)

Evaluating and Choosing REITS

Don’t fret over the insider-information ban. When shares of corporations or REITs trade in the public securities markets, there is plenty of information available. Although you can’t call insiders and ask your juiciest most off-the-wall questions, the SEC still wants you to know what you’re doing. As a result, the regulators and the accounting profession have de facto partnered up to establish a large and detailed set of standards governing information that has to be publicly disclosed and the standards requiring how facts are to be gathered and presented. It may not be exactly what you want, but if this sort of thing is good for the Warren Buffetts of the world, it should be more than ample for us. (If you don’t the know who Warren Buffett is, Google the name: Real estate seminar peddlers and the like love to bash the stock market, but they can barely dream of accomplishing even a percent of what he has.)

Users of such information (investors) have many ways to analyze the available information. This isn’t really the place to get into it (it’s a lot) and I’ve already written a ton about it elsewhere (see, e.g., Screening the Market (Wiley 2000), The Value Connection (Wiley, 2002), on-line virtual courses and ongoing on-line commentary). REITs are a bit atypical relative to most manufacturing and service companies, so other experts in the public securities markets have written books showing how the publicly available information can be used in connection with the specialized securities.

A Proposed New Blended Approach

Being firmly planted as I am in the stock market world (as Director of Research at portfolio123.com and registered Investment Advisor Representative) and being a Realtor®, it occurred to me that it should be worthwhile to draw on the body of knowledge in both fields. So I developed a strategy that uses publicly-disclosed data on REITs to mimic, to the extent feasible, the sort of cash on cash returns that guide real estate investors. In other words, I’m looking to combine the worlds of Warren Buffett, Graham & Dodd, Jim Cramer, et. al. with the world addressed by BiggerPockets.com and the countless Real Estate Investors Associations out there.

I published about it last week on forbes.com. Here is an excerpt of that article that discusses the approach I use and presents some test data that suggests could be a promising way to go:

My Approach

The ideal for any income seeker is to simply invest in the securities offering the highest yields one can find. The reality is that the higher the yield, the more likely it is that this is being caused by declines in prices due to selling pressure from investors who anticipate a divided cut or elimination. Therefore, the income-seeker’s task is to identify the highest yields available for a subset of the dividend group that is likely to be able to at least maintain the level of the dividend (the ability to grow the dividend would also be nice).

Based on that logic, I rank “eligible” REITs by yield and choose the top 5 issues. Whether the model I use succeeds or fails will depend on how successful I am in prequalifying the group to eliminate actual or potential dogs before I sort for yield.

Here’s how I do it:

• I start by eliminating a group known as mortgage REITs. I want genuine real estate operations, not wannabe-but-less-regulated banks. The data I use doesn’t work for them and I’m not confident in my ability to evaluate the kinds of risks they present.
• Next, I try to weed out dividend problems that have already surfaced. I ban REITs that have eliminated the dividend  in any of the last four quarters.  In a perfect world where we could always count on dividend achievers, dividend aristocrats, etc., I’d also expel REITs that have reduced, but not completely eliminated, the dividend in any of the past four quarters. But if we’re going to focus on business rather than investment-guru factors, we have to cope with the reality that sometimes, life su***. As pass-through entities required to pay pretty much all their earnings to shareholders (which means they don’t have the luxury of being able to pay out much smaller portions of earnings so they can smooth things when they hit some turbulence), even good, worthwhile, REITS are going to reduce payouts every now and then. We’re trying to reduce the likelihood this will happen in the future while we hold the shares, but if we wag our fingers every time it happened in the past, we’ll eliminate far too many meritorious operations. So I’ll tolerate reductions in dividend over the past four quarters, so long as the drop wasn’t so severe as to be the functional equivalent to an elimination.
• The next test may come as a surprise considering how I waxed poetic about the virtues of the high-to-low yield sort. No REIT makes it into my sorting if its yield is in the top 10% relative to the REIT group. In my experience, I’ve seen many times that the best way to handle a sort is to quickly wipe out the very top (the candidates assumed by naive observers to be the cream of the crop). I don’t want to get into debates on market efficiency or mean-reversion here, but I have found, by observation and by research, that Mr. Market is remarkably good at recognizing the most dangerous income plays and signaling the world by pricing the securities such as to push yields up to the stratosphere. It’s as if you’re looking to buy a house and comparable properties in the area have been going for about $650,000 and your agent proudly suggests one that photographs beautifully and is listed at $280,000. If the agent doesn’t the have an immediate and credible answer when you ask “What’s wrong with it?” (as I hope you would), decline the showing and find a new agent.
• Next I look at cash-on-cash return and limit consideration to REITs that rank in the top 50% of the group when the numbers are calculated for the trailing 12 months and also over the past five years. This does not have a direct and immediate impact on capacity to pay dividends,  but bad numbers here do suggest possibilities with which I’d rather not associate: Relative to other REITs, those with bad cash-on-cash returns are overpaying for properties and/or aren’t great when it comes to extracting cash flow from them. (A private investor with suitable liquidity  might tolerate low or even negative cash-on-cash returns in anticipation of changes that will produce strong price  appreciation. But that doesn’t work for REITs that are seen as income vehicles.)
• Finally, I address (debt) leverage. REITS, whose debt is typically secured by mortgages on income-producing properties can and usually do carry heavier borrowings than do many other kinds of businesses. But even here, there comes a point where enough is enough. Banks understand this and those that choose not to act like reckless jerks have standards regarding how much debt a property can safely carry. This is important: Real estate operators are remarkably adept at seeing to it that when projects fail, it;’s somebody else’s money, not theirs, that vaporizes. So I won’t invest in a REIT with a debt-to-equity ratio above 2.

Those are my gatekeepers. (I tried working with capitalization rate too, think of it as a cousin to operating margin) but haven;’the yet found a strategy in which it’s productive for my purposes.) Among the limited number of REITs that make it into my personal promised land, I’m comfortable picking the five with the highest yields.

The Catch —sort of

This strategy requires a genuinely low-cost brokerage account. The model and the stock list is refreshed every four weeks and you can expect to trade at least one and usually more stocks on each occasion. In a way, though, this evens the scales for public shareholders viz. hands-on operators. They have the advantages of control and more precise information. So we owe it to ourselves to take advantage of the built-in edge we have; we can get in and out a heck of a lot more easily than they can. Simulations I’ve done suggest you should expect to turn the portfolio over 5-6 times per year. So think of yourself as a dividend trader rather than a long-term investor.

Performance Testing

I know past performance assures us of nothing regarding the future and relative to quants in the investment field, I’m probably more open and loud about this. But I also understand that if a strategy is based on ideas that make sense, rather than a statistical treasure hunt to see what just so happens to have worked in one or more past periods, you can learn a lot from backtesting. So in that spirit, I offer some tests of this strategy in comparison to a simple one-stop buy-and-hold REIT strategy; the Vanguard REIT ETF (VNQ).

Before getting to the nitty gritty, let’s start with dessert: the yields.

Table 1

Dividend Yield %
Model	6.37
VNQ	4.37

That’s a good start. Now, though, the question becomes whether the high yield comes at a cost; lesser share gains and/or greater losses.

Basic backtest results are shown in Table 1. These are “total return” figures that reflect the impact of dividends and share price change.

Table 2

	Last 10 Yrs.		Last 5 Yrs.		Latest 12 months
	Model	VNQ	Model	VNQ	Model	VNQ
Total Return %	94.95	90.32	98.54	50.88	25.11	3.47
Ann’l Ret. %	6.90	6.65	14.70	8.58	25.11	3.47
Max Drawdown	63.77	-70.99	-22.58	-17.36	-12.76	-12.39
Stan. Dev. %	25.37	26.30	17.02	13.70	22.15	12.10
Ann’l Alpha % *	5.37	2.32	12.46	5.42	18.05	-0.19

* In all cases, Alpha is computed relative to the a generic fixed-income ETF, the Vanguard Total Bond Market RTF (BND).

Table 2 shows a “rolling” backtest. It addresses for the possibility that what we see in Table 2 reflects the luck of the draw when it comes to the starting date; in other words, whether things might look different if we started the test on a different day and, hence, had a different set of once-every-four-week re-runs of the model. In the rolling test, we look at a lot of self-contained four-week portfolios that start every week. Here, we examine the results of all these one-shot portfolios (519 of them in the 10-year test) and compare the average returns achieved over the course of the four week intervals to the average return for the benchmark (the VNQ ETF) during those same four-week periods.

Table 3

Avg. of 4-week Tests	Average Return %
	Model	VNQ	Model Excess
Latest 10 Years
All	0.76	0.49	0.27
Market Up	1.53	1.43	0.10
Market Down	-0.74	-1.33	0.59
Latest 5 Years
All	0.98	0.47	0.51
Market Up	2.04	1.75	0.29
Market Down	-0.67	-1.51	0.84
Latest 12 Months
All	0.73	-0.16	0.89
Market Up	1.31	1.17	0.14
Market Down	0.09	-1.65	1.74

Current Portfolio Holdings

Here are the five REITs currently in the portfolio:

• CoreCivic (CXW): A private prison operator with a yield of 6.48% previously discussed by me.
• LaSalle Hotel Properties (LHO): A portfolio of upscale full-service hotels in major urban, resort or convention locales whose REIT shares yield 6.19%
• Outfront Media (OUT): A provider of out-of-home advertising structures and sites mainly highway billboards; the yield is 6.75%
• RLJ Lodging Trust (RLJ): A portfolio of premium-branded compact full-service hotels with a REIT yield of 6.08%
• Sabra Health Care (SBRA): Invests in skilled nursing and assisted living-type facilities; the shares yield 6.18%

This is not a SWAN (sleep well at night) portfolio. For that I suggest a good Pinot Noir or something that yields, say, 2% or less. So don’t expect to look into any of these REITs and marvel about how all is great and wonderful. But that’s life nowadays. If you want big yields, you need to be able to live with baggage, or sleep well at night after a strong Espresso. This strategy takes on the baggage only because of the screening tests I use that seek a high probability of hanging in there until the next monthly re-run of the model. (I tested with longer holding periods: Not great.)

Finally, I do need to mention that this list is the result of the model having been updated on September 4. So we’re pretty close to the next update, at which all or some may get the boot. So if you’re interested in this strategy, rather than buy you may want to familiarize yourself with these REITs to get a sense of the kind of baggage you have to carry in order to earn your yield.

We’re in the latter stages of a significant project that will, when completed, allow you to follow or directly invest in this strategy on portfolio123.com, as well as a bunch of others including more designed for income seekers (one being a bond-laddering strategy based on what I wrote here).

For now, I’ll update holdings in as timely a manner as I can through additional posts on this site.