Which REIT Sectors I Prefer: Focused Investing Newsletter #15

A change of pace from sunsets. My hill is becoming a wildflower garden. I love these orange ones.

One of our members asked for my overview and ranking of the REIT sectors, with my thoughts on relative strengths and weaknesses. This is almost orthogonal to my usual focus of singling out the “best” REITs by some standards.

You can lose money in the sectors I like. And you can make money in the sectors I don’t favor. So this discussion is only good for context, not action. Anyway, here we go, in order:

Net Lease REITs

These REITs lease free-standing properties to single tenants on “triple-net” leases, under which the tenant is responsible to all maintenance, taxes, and insurance. They thus escape some of the costs that impact returns for other REIT classes.

When they purchase a property, often via a sale-leaseback, and establish whatever debt helps pay for it, they lock in known returns with known escalators. The only uncertainties are these:

• possible costs to roll debt

• the value of the property on lease expiration

• possible consequences of tenant difficulties

The result is that these REITs produce earnings and dividends that are quite reliable. More variable is the growth rate, which depends on many factors.

These REITs operate in multiple economic sectors, notably including retail, manufacturing, logistics, experiential, and office. The casino REITs are often described as a separate sector, but they do operate just this way. I personally favor the retail ones, but only slightly.

Multifamily REITs

The multifamily REITs at minimum own apartment buildings that they rent to tenants. But few do only that.

The ones I prefer emphasize development, redevelopment, and capital recycling. They are able to exploit the typical spreads between development yields and disposition yields.

These REITs do have additional costs — property operations costs, property taxes, and maintenance expenditures. Net Operating Income (NOI) usually allows for the first two but not the third. It tends to run near 10% of NOI.

But between profitable development and geographic flexibility, the best of these REITs have grown FAD/sh at 5% to 6% (FAD being Funds Available for Distribution). This is a bit better than the Net Lease REITs will typically do.

Unfortunately, the multifamily REITs uniformly pay low yields. They are best bought when the market is in a funk, or by someone for whom the steady income and/or long-term growth are enough.

Shopping Center REITs (and Malls)

Such REITs also own and operate properties. They often use triple-net leases to rent to tenants, but they still must cover expenses for the overall center. On top of that, they have to cover the expenses necessary to replace tenants who leave.

The explicit costs run around 10% of NOI, but there is also up to a couple years of lost rent while vacated space is re-leased and prepared for the next tenant. FAD as a fraction of NOI ends up near that of multifamily REITs.

Office REITs

Office is unpopular right now, for good reason. The whole sector is facing economic readjustments to hybrid work schedules and to higher interest rates.

Still the best buildings are leasing up and commanding great rents. One problem for the office REITs is that nobody owns only such buildings.

Another problem is that REITs are challenged to grow earnings in this sector. One contributor is large costs for building capex and large costs for improvements for new tenants. These are in the 15% to 20% of NOI ballpark, well above the level for apartment or shopping REITs.

Chris Volk’s theory is that (in non-stressed times) cap rates for office get bid down by people who want to own trophies (especially international buyers). Whether or not that is the story, the numbers just don’t support rapid growth.

Some of these REITs may gain in the long run by buying distressed properties soon. SL Green (SLG) is certainly trying. But at best that is long-term.

Still my view is that the office sector is past the worst. And they are paying better dividends than they once did, as you can see here.

When I looked at Boston Properties (BXP) last year, my conclusion was that a dividend cut was unlikely. And SLG alread had theirs.

But the yields today are near those of W.P. Carey (WPC) and VICI Properties (VICI). I would expect both of those to grow faster. That said, if yields diverge so that the good office REITs are significantly higher, I might put some money there.

Housing REITs

Both rental housing and manufactured homes grew rapidly through the 2010s and paid horribly low dividends. The exception was UMH Properties (UMH), a family business who is not about to engage in sensible management, but does pay a higher yield.

The macroeconomic context certainly seems favorable for these REITs in the 2020s too. But what will happen with dividends is the question for me.

I do have it on my list to look closely at Sun Communities (SUI). It has been awhile.

Sectors Less Attractive to Me

I mostly avoid several REIT sectors. Here are brief summaries of why.

Healthcare

The healthcare sector is actually a hodgepodge of quite a few different property types. I do like LifeScience, in spite of current overbuilding, and am invested in Alexandria Real Estate (ARE).

My issue with patient-treatment facilities is that their services are not priced in any market. They are essentially dependent on government decisions of some sort.

One consequence is that you see a lot of REITs making loans to their tenants, to provide capital for updates and improvement. There is nothing inherently wrong with that, but in this sector it is far from sure that the increased costs can be recovered. We’ve seen quite a few operator bankruptcies that have seemed, strangely, to catch the REITs by surprise.

Then when you come to Senior Housing the story is again different. The sector is market priced but is very subject to overbuilding. In addition, as technology increases the practicality of staying in a house, the demand may fall short of expectations.

The two big healthcare REITs are Welltower (WELL) and Ventas (VTR). I took a close look at WELL last year. Their properties have clearly lost value over time, a very unusual and negative result for a REIT. I also did not like their poor disclosures.

Industrial

There are some really good companies doing industrial. But the sector is extremely subject to overbuilding. Consider me skeptical of the claims that space is not available in some metros, as well.

My issue is whether one can see an oversupply crisis coming. That did not happen in 2007; look at this:

After 2007, it took a decade for PLD to recover in stock price and total return. Cash from Operations per share did not recover for 15 years.

I just do not know how to be sure that won’t happen again. And dividend yields are quite small, too.

Self-Storage

Industrial is subject to oversupply, but self-storage is worse. On top of that, I have no clue how to see big changes in demand coming and dividends have been small.

The surge in 2021 was unexpected. So was the collapse after that. You can see the feast and famine aspect in this plot from Public Storage of America (PSA).

On top of that, self-storage seems pretty built out in the US. I think maybe Big Yellow Group in Great Britain, advocated by Jussi Askola, is a reasonable play.

Data Center

It is not ultimately clear that one can make money running data centers. Too much capex.

One can make money building them. But (I think) there is no longer a REIT play with good access to that.

IF the AI hype is realized, then there will be massive demand for space in data centers. Well, maybe, but I’m not betting a horse on that, let alone the house.

Lodging REITs

These are just strange business models. The REITs carry all the risk from variations in customer behavior. Long-term this sector has among the worst returns and no wonder.

Other Stuff

Mostly I am not fond of RINOs — REITs In Name Only. These run ordinary businesses within a REIT legal shell but do not own and lease properties.

Examples include Billboard REITs and Telecommunications REITs. Safehold (SAFE) is also a RINO, but of a rather different sort.

These may be good investments, but need to be thought about as though they were ordinary C-Corps.

Recent News (that caught my attention)

Economic News:

• Nothing dramatic caught my eye.

• Interesting that Europe is beginning to push down interest rates while the Fed is not.

Midstreams & Other Energy:

• Two top Canadian oil and gas lobby groups said this week they were forced to removed content from their websites and social media platforms because of a new law. They claim that it seeks to silence their members in touting their progress fighting climate change.

REITs:

• W. P. Carey (NYSE:WPC) announced that it has priced an underwritten public offering of $400 million aggregate principal amount of 5.375% Senior Notes due 2034.

• Moody’s downgraded the credit ratings of Hudson Pacific (HPP), lowering its senior unsecured debt rating to “Ba3” from “Ba1” and its preferred stock rating to “B2” from “Ba3” with a negative outlook

• Simon Property (SPG) announced with WHP Global, Brookfield Properties and Centennial Real Estate the formation of PHOENIX, a new retail operating platform. The consortium purchased out of bankruptcy and will operate all direct-to-consumer commerce in the U.S. for the Express and Bonobos brands and over 450 physical stores. Simon has commented that they will not be putting cash into this venture. It will be interesting to see what more they say about it later.

• Santa Monica-based REIT Macerich is giving Santa Monica Place back to its lender. Their CFO: “We've got a challenging underlying capital structure and that all led us to making the decision to default on the loan in early April." This is one small step in what will be a long story.

Member News

This week featured

items that went to all members:

• A weekly newsletter.

Items that went to paid members:

• A deep dive on Apache (APA corporation). Brief Note on property values.

Changes to the Google Sheets (for annual members):

• I have moved the REIT assessment sheet to a tab on my portfolio sheet.

• An initial version of a Midstreams assessment sheet is a tab on the portfolio sheet.

Also:

• A lot of ongoing random discussions occur on the Focused Investing chat. One can also post items of interest, which I do often. Check it out and post your own items, please.

• Annual paid members should have access to the live, real-time portfolio showing all my stock-market investments, and to the Sheet showing my assessments of selected REITs. (If you don’t have that access, contact me). Comments and questions are welcome.