The Intelligent REIT Investor Guide. Brad Thomas
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REITs are superior to most common stocks in this regard. Analysts who follow these companies are normally able to accurately forecast quarterly results, within one or two cents, quarter after quarter. This is because of the sheer predictability of the operations at work, especially when it comes to any property type that uses long‐term leases (which is most of them). That provides earnings stability that can't be found very easily elsewhere, further reducing both risk and volatility.
As a result, relatively few REITs have gotten themselves into serious financial difficulties over the years. Those that did were generally poorly managed and/or burdened by risky balance sheets.
Less Risk
Make no mistake: There are times to buy and sell. But prudent investors control their emotions, oftentimes by filling their portfolios with low‐risk positions like REITs.
As we already established, there's no way to avoid risk completely. Even simple preservation of capital carries its own risk, with inflation taking its typical toll on almost everything. So it should come as no surprise that real estate ownership and management comes with potential problems too.
The previously referenced Cohen & Steers report already broached the subject. It's easy to see that retail REITs are subject to the changing spending habits of consumers and that rising online capabilities are affecting offices. But every other property type comes with its own set of potential pitfalls. For instance, apartment REITs have to deal with varying popularity of single‐family dwellings and/or declining job growth. And the healthcare subsector constantly battles government decisions concerning healthcare reimbursement.
Again, there is no perfect investment. I can't stress that enough. The global pandemic and consequent government shutdowns certainly put significant stress on many REITs, especially already struggling malls, which we'll discuss in Chapter 5. Even so, the unique blocks these investments are built on do make them very worthwhile considerations.
The fact that they simultaneously provide a steady income of dividend payments even during the occasional bear market doesn't hurt either. They literally pay us to wait.
Higher Current Returns
Chapter 3 discusses the actual creation and evolution of REITs. For now, just understand that they pay out at least 90% of their pretax income to shareholders in the form of dividends. The result is typically higher dividends as a percentage of their free cash flows (FCF) and higher dividend yields to boot.
In addition, to stay compliant with the law, REITs usually have to increase their payouts as rents rise over time, historically resulting in steady dividend growth.
Some academics claim shareholders shouldn't care how much of a company's net income is paid out this way. But others argue that dividends really do matter with respect to shareholders’ total returns.
In September 2010, Barron's quoted Ed Clissold, an equity strategist at Ned Davis Research. His research showed that the S&P 500 had delivered average annual price appreciation of 4.92% since the end of 1929. But its average annual total return had been 9.16%. In other words, dividends provided approximately 46% of those total returns, indicating that they do indeed count. A lot. And we haven't seen any evidence of that principle changing in the last decade.
Another related benefit is that REIT shareholders can participate in income reinvestment plans, plowing their dividend income back into their holdings by buying additional shares. Or, should they so choose, they can invest it elsewhere or spend it on a vacation in Hawaii. Other shareholders don't have this advantage. They have to accept whatever decisions the board of directors puts in place in this regard.
Skeptics may point out that REITs’ featured dividend yields are often below those of many corporate bonds. However, bond interest payments don't increase, whereas the REIT industry has a long‐term track record of increasing dividends on a regular basis. The Great Recession and 2020–2021 Covid‐19 pandemic both interrupted that run, it's true. But over time, their dividend action has still proven to outpace inflationary forces.
Back to Cohen & Steers again: “Real estate has inherent inflation‐hedging qualities that we believe can help investors defend against erosion in buying power resulting from the rising cost of living.” This includes how an inflationary environment can restrain new developments by pushing up the price of everything from land to materials and labor. As a result, landlords are in a better position to raise rents.
The article also mentions this: “Many commercial leases even have explicit inflation links, with rent escalators tied to a published inflation rate. As a result, REITs have historically benefited from inflation surprises, contrasting with the adverse reaction from broad stocks and bonds.” Covid‐19 did halt inflation for a time, but the long‐term trend tells us that will change soon enough.
On a slightly separate note, there's also an intangible psychological benefit in seeing significant dividends roll in so consistently. Seeing a check come in for several hundred dollars every quarter – without the usual effort on your part – can provide substantial comfort … regardless of whether you intend to spend it or reinvest it.
High Current Returns Versus Slow Growth
Many people understandably wonder if those high dividends have a negative effect on REITs’ growth prospects. After all, their 90% pretax‐income payouts mean they can only keep so much money to build on.
Stock prices do indeed appreciate from rising earnings growth. Therefore, REIT shares do usually rise at a slower pace than non‐dividend‐paying companies. However, this is perfectly acceptable to their investors, who expect to make up much – or even all – of the difference through higher dividend payments over time.
Consider the study presented in the January/February 2003 issue of Financial Analysts Journal. Entitled “Surprise! Higher Dividends = Higher Earnings Growth,” it was written by hedge fund manager Cliff Asness of AQR Capital Management and academic Robert Arnott of Research Affiliates. Together, they concluded that the earnings growth rates of companies with above‐average dividend payments are actually higher than those with lower offerings.
These results tend to defy logic, I know. But the latter kind of company doesn't always do a good job of reinvesting its retained capital. Why should it? There's not the same incentive to be careful in this regard.
Regardless, REITs do have other means of obtaining growth (yet another to‐be‐discussed topic, this time in Chapter 10). They can make additional stock and debt offerings, exchange new shares or partnership units for properties, or get creative with buying and selling strategies.
With all that said, when dealing with most subsectors, it's often best to have relatively conservative expectations. In most cases, investors would be wise not to expect more than mid‐single‐digit growth over the long term. And when those conservative expectations are blown out of the sky, you'll want to do your due diligence.
It's not an automatic warning flag when a REIT's stock just keeps climbing. Some sectors perform better than others at varying times, which only makes sense. Real estate is a cyclical industry, so there will be down years. But rental rates do grow over time, meaning that healthy REITs’ cash flows will grow as well.
These assets don't promise instant riches or even perpetual investment tranquility. But the sector does make for excellent long‐term investments nonetheless. I've seen it happen too many times for myself and my readers to doubt that fact.
CHAPTER 2 REITs Versus Competitive Investments
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