An Introduction to REIT Investing

One of the regular search terms that brings people to this site is: “Should I buy REITs” followed closely by “Are REITs conservative investments.” Sometimes, people think about REIT investments as identical blocks of real estate that have few differences between them. That, of course, is not the right perception. Just as there is a difference between buying and holding Coca-Cola and ExxonMobil for thirty years compared to holdings and Iron Mountain instead, there is a wild divergence in the quality of REIT investments that a person can make. Let’s walk through a couple examples.

The most conservative way to find an investment in real estate is to find one of the rare companies with an excellent balance sheet and a business model that retains customers during economic recessions without having to make many price concessions to them.

An example of a company that fits this conservative profile is Public Storage (PSA). It’s the company that owns 2,250 places where you store your own stuff for a monthly fee of $50-$500 per month, depending on the geographic area and specific accommodations you want (size, security features, etc.) It is a nice business model because the core constituency needs to use storage space perpetually to keep miscellaneous objects from their business or home.

Around the edges, the company benefits from both economic expansions and contractions because each of those circumstances prompt the need for storage facilities. When the economy is growing, people buy decks, add rooms to their house, purchase furniture, and often need storage space for the transition. Heck, people move to different houses altogether. Merger and acquisition activity also tends to pick up on the business side, and this leads to excess inventory being stored as the management of the merged company tries to figure out what can be kept and what is duplicative.

During economic downturns, people move (not by choice) and businesses consolidate costs in an effort to become “leaner”, as the Wall Street buzzword goes. This also protects the demand for storage facilities when the economy is not doing well. And this story plays out in the numbers. Between 2007 and 2009, Public Storage increased its funds from operation from $4.74 to $5.03. The dividend held steady at $2.20.

This is exactly the type of business you want to own for the long haul, as the company avoids the “reset” of having to rebuild profits after a deterioration. Investors in companies like Citigroup and Bank of America will lose about fifteen years of compounding when it is all said and done because each of those banks made disastrous decisions that will require years and years of growth to get back to the status quo.

A business like Public Storage avoids that because (1) the profits are real monthly payments coming from customers, and this has driven the FFO growth from $3.61 in 2005 to $8.65 in 2015, and (2) the company maintains a conservatively managed balance sheet. It has $64 million in debt. It makes more profit than that per month.

Peter Lynch once said his favorite people in business were the managers of trash companies because they pull no charades with the numbers and just try to grow the business the old-fashioned way. That captures my sentiment with Public Storage. Over the past 35 years, Public Storage has delivered a compounding rate of 12.2%, which turns $10k into half a million.

Now, let’s talk about the Hospitality Trust REIT (HPT). With the share price under $30, the annual dividend yield is approaching 7% as the company pays out $1.96 per share in dividends. This fact has gotten a lot of attention from people who want to make an investment that produces a high amount of right now. The majority of analysts now recommend the stock a buy. For those of you not familiar with the company, the Hospital Trust owns the real estate for about 500 locations in the United States plus Puerto Rico.

What people tend to forgot about the Hospitality Trust is that the company is in no way equipped to ride through recessions in strong shape. Heck, it still hasn’t recovered from the last recession. This year, you get a $1.96 annual dividend and $3.50 in funds from operations. Back in 2007, the Hospitality Trust paid out $3.08 in dividends and made $4.22 in funds from operations. It’s eight years later, and the company still hasn’t recovered from The Great Recession. The dividend got slashed and the price fell to $6 per share in late 2008. Over the past ten years, the returns have only been a bit more than 4% annualized. That’s what happens when you have to rebuild. Vacation real estate is highly susceptible to turns in the economy, and the returns of the Hospitality Trust over the past decade confirm this point.

And perhaps the golden goose of REIT investing—and this objective extends to all investing in general—is finding companies with strong growth and a low risk chance of getting harmed by a recession. The best candidate I’ve studied that fits this billing is Ventas. It is the company that runs nursing homes, and makes a whole lot of money doing it. It benefits from the trend of an aging America, and has delivered 13.5% annual returns both over the 2005 to 2015 measuring period as well as the 1997 to 2015 period (the company itself only has an independent history dating back to 1997, though it was part of Vencor before that.) The dividend goes up every high, and the shareholders benefit from high single digit growth as nursing homes are very expensive and Ventas enjoys 18% operating margins. The dividends and profits have never gone more than two years without increasing in the company’s corporate history.

There is also a category of high-risk, little-reward investing that I did not want to profile in this post (though I have called attention to some REITs with questionable long-term business models and valuations in the recent past.) At least with something like Hospitality Trust, you can buy during a recession and ride the wave through the next economic cycle. A 2009 Hospitality Trust investor would be collecting $1.96 in dividends on a $7 investment for a current yield-on-cost of 28%. And that is assuming no dividend reinvestment over the past six years. If the dividend holds steady between 2015 and 2018, a 2009 Hospitality Investor would have received more in dividends than the actual investment amount alone. It seems in the realm of intelligent speculation during a bear market.

But it still wouldn’t be the kind of thing I’d want to own for 20+ years because the damage done during a recession wipes out years and years of growth that sees the stock price deservedly plummet and the dividend get slashed as profits fall. You don’t need to buy businesses that have that kind of turbulence built in. The companies like Ventas and Public Storage, meanwhile, have the ability to weather deep economic recessions because Public Storage customers still use storage facilities during a decline (if not for the same fun reasons that would prompt usage during an economic expansion) and elderly people don’t suddenly say—it’s 2009, this recession is bad, and I’m going to peace out of this nursing home.

None of this should necessarily be taken as a buy recommendation for any of these stocks (it’s especially not a buy recommendation for Hospitality Trust.) Instead, it’s my way of pointing out that the variety of quality regarding REIT investments is very similar to the divergence among regularly traded C-corp stocks without REIT status. The best way to figure out which ones are worth buying and holding for the long haul involves digging in and mentally understanding the story of the business model, and then relating the story to the actual numbers to see if management’s actual business practices match the abstract vision you have of the business in your head.


Originally posted 2015-06-13 22:33:28.

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