The Intelligent REIT Investor Guide. Brad Thomas

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The Intelligent REIT Investor Guide - Brad Thomas


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safety of its principal and interest may be unquestioned, a long‐term bond could vary widely in market price in response to changes in interest rates.”

      —Benjamin Graham

      When deciding if REITs are appropriate investments for you personally, it's often helpful to compare them with other assets. Admittedly, this isn't always easy considering how unique they truly are. But I still see it as a worthwhile endeavor, hence the purpose of this chapter.

      To start off, REITs trade as stocks because, technically speaking, they are stocks. Yet they're markedly different from companies such as General Electric, Microsoft, or Disney because of their higher dividend yields and more modest capital appreciation prospects. Therefore, while it's useful to compare them to the broad equities markets, it might be more worthwhile to put them up against bonds, convertible bonds, preferred stocks, and higher‐yielding common stocks, even master limited partnerships (MLPs).

      These are the investments of choice for income seekers looking for lower volatility, zero to modest capital appreciation prospects, and reduced risk. So let's look at each of them.

      The same cannot be said about REITs.

      With bonds, what you see is what you get: pure yield and very little else. Take a $10,000 investment in a bond that yields 5% and matures in 10 years. At the end of that decade, you'll have your $10,000 in cash, plus the cumulative amount of interest received (10 × $500) for a total of $15,000.

      Now let's say you purchase 1,000 shares of a REIT trading at $10 that offers a 4% yield ($0.40 per share). It also increases its adjusted funds from operations (AFFO) – which, as we'll discuss in more detail later, is a rough approximation of FCF – by 4% annually and its dividend the same amount. The shares then rise in price 4% as well.

      Taxes, of course, will have to be paid on both, cutting into profits on either side. And conventional wisdom says that REITs should provide a higher total return in the end since they're riskier than bonds. However, that's not necessarily true if we consider the bond owner's exposure to inflation. REIT shares offer no specific maturity date, and there's no guarantee of the price you'll get when you sell them. However, bonds have no inflation protection. Their holders are at substantial risk of seeing their purchasing power decline with the dollar.

      It's all a question of how one measures risk.

REITs: 4% annual dividend compounded at a 4% annual growth rate
End Year Stock Price Per‐Share Dividend
1 $10.40 $0.400
2 $10.82 $0.443
3 $11.25 $0.450
4 $11.70 $0.468
5 $12.17 $0.487
6 $12.66 $0.506
7 $13.17 $0.527
8 $13.70 $0.548
9 $14.25 $0.570
10 $14.82 $0.593
$4,992
1,000 shares $14,820 $4,992
Total Investment value $19,812

      Source: Investing in REITs by Ralph Block.

      Admittedly, a REIT's stock price may decline in response to higher interest rates. But interest rates often climb alongside a growing economy, which helps to grow REIT cash flows over time.

      For those who want to point out U.S. Treasury bonds as a solution, yes, those aren't callable prior to maturity. And, yes, they entail no repayment risk. But their yields are lower than those of corporate bonds, and they still fluctuate with interest rates regardless.

      Bonds are certainly suitable investments for most investors. However, they shouldn't be regarded as good substitutes for REIT stocks in a broadly diversified portfolio. Nor should REIT stocks be seen as good substitutes for bonds.

      In general, these assets provide the security of fixed maturity dates in case their underlying common stocks fail to appreciate in value. So they can be relatively attractive investments.

      The main problem here is that most companies just don't issue them. Some REITs have occasionally issued convertible securities, including convertible preferred stock. But investors should consider whether the extra safety they provide outweighs the often substantial conversion premium and their relative lack of liquidity.

      Many investors seeking higher yields have become interested in preferred stocks, including those issued by REITs. (That's one reason we included an entire segment on preferred shares later in the book.) Unlike bonds, these shares aren't guaranteed by the company in question to repay a specific amount at a specified date. And in the event of liquidation or bankruptcy, preferred shareholders’ rights are subordinated to those of the corporation's creditors.

      With


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