EP 17 | WHY YOU SHOULD NEVER INVEST IN AN REIT

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Hosted by
ANDREW LANOIE

Today on “The Impatient Investor” Andrew discusses how investor REITs should never be an option and on recession vulnerability.

For smart investors, looking for recession-proof returns with unlimited upside and access to management REITs should never be an option.

Andrew Lanoie

Real estate investment trusts or REITs are a convenient way for inexperienced investors to gain exposure to real estate investing, especially for the first time.

Modeled after mutual funds, publicly traded REITs purchase own and manage real estate properties, REITs give individual investors the opportunity to invest in a portfolio of income producing real estate. Investors don’t typically need a large amount of time or resources to invest in REITs, but for the savvy smart investor REITs should never be an option. Let’s talk about recession Vulnerability.

REITs are highly vulnerable to recessions on two fronts. Because publicly traded REITs are highly correlated to the stock market recessions always lead to an associated drop in REIT prices. In fact, since 2008, REITs have actually proven more volatile than the broader market. This is because the balance sheet of REITs are susceptible to external shocks. It is caused by the REITs inability to retain significant amounts of cashflow and without cash to ride out downturns they are forced to liquidate assets at bargain prices.

During the 2008 financial crisis as stock prices fell, equity volatility
for REITs increased. Not only our REITs prices susceptible to recessions and downturns, but they are hypersensitive to market shocks compared to the broader market. Economic downturns, not only affect REIT share prices, but with the associated reduction in rents, REIT profitability and dividends also suffer as a result.

Now for the limited upside, a variety of factors limit the upside benefits of investing in REITs. One of the main downside of REITs is because they’re highly leveraged in increase in interest rates and therefore the borrowing rate directly impacts the cost of acquisitions and refinancing. Interest rates are at an all-time low currently, chances are they will increase in the future. Here’s a great quote.

Besides higher interest rates will eventually slow down economic growth and hurt occupancy rates, rents and income payout rates.
That was the author of good bad and ugly REITs from Forbes.

In the current environment with historically low interest rates, the only way is up. Increase in interest rates will result in downward pressure on the bottom line
of REITs, therefore limiting the upside potential.

Another factor to consider limiting the upside benefits of REIT investments is the lack of diversification and competition. Most REITs specialize in a single property type and a weakness in that particular segment of real estate could limit returns. This can be currently seen in the residential market and imagine owning a REIT comprised of retail and office building assets. Because residential REITs have grabbed investor attention in recent years and has been flushed with investor cash, this has resulted in a glut of supply. Usually higher supply curtails, the landlord’s ability to demand higher rents and leads to lesser absorption. These may keep the growth momentum of rent at check.

In the fourth quarter of 2006, the national effective rent growth increased
2.3%. And that was according to the early apartment data from Axiom metrics. This was over two percentage points lower than the 4.6% rent growth experienced in the year ago quarter. Also occupancy of 94.7% in the fourth quarter was down from 95.1% in the third quarter and 95% in the fourth quarter of 2015. The lack of diversity in widespread competition can limit a REITs upside prospects.

A REITs pre-established term can also limit the upside of its investment. Because REITs typically have a fixed maturity of 5 to 10 years, at some point, the properties must be sold regardless of market conditions. That means if
the REITs matures at any time when prices are down a drop in your investment will be unavoidable.

Finally, because REITs can only reinvest a maximum of 10% of their annual profits back into their core business each year, this limits their growth and upside potential as well.

What about access to management? Investors often align their investment philosophy with that of the management who had the companies that they seek to invest in. As with most public companies access to the management team of REITs is prohibitive. This limits the investor’s ability to analyze a team’s competence envision going forward. For smart investors, looking for recession-proof returns with unlimited upside and access to management REITs should never be an option.

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Episode 17