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Reit Red Flags

Reit Red Flags

Five things to watch out for when evaluating REITs

When it comes to REIT investing, you likely have your own method for determining which REITs offer the best investment opportunity. Total return and dividend yield are certainly two of the most popular metrics used to identify those oh-so-desirable REITs.

But what tells you that a REIT might not be such a good bet for your clients? What pieces of information throw up a red flag, shouting out, “Wait a minute! Are you sure about that?!”

Here, Registered Rep. identifies five red flags that will help you evaluate REITs so you can make sure your clients get what they need to achieve the best investment results.

Red Flag #1: Consistent poor performance

REITs obviously own real estate, so their performance can be influenced not only by overall market ups and downs, but also by real estate cycles. Thankfully, there are so many different entities that track REIT performance, it's not difficult to figure out how well different REIT sectors are performing, as well as the performance of specific REITs.

When evaluating REITs, it's important to put REIT performance in the context of the broader market, in addition to the REIT industry and different property types. A REIT that performs poorly when the overall REIT industry is doing well or when its peer REITs are showing strength should be carefully evaluated. Moreover, REITs that pay dividend yields lower than the rest of the sector — or don't pay them at all — require a second thought. (It's worth noting that REITs cannot suspend dividends indefinitely or they will lose their REIT status with the IRS.)

Red Flag #2: Dangerous debt

Several years ago as I interviewed a prominent mortgage banker, he told me, somewhat tongue-in-cheek, that it is “un-American to not use debt.” He was referring to commercial real estate investors who paid for properties using nothing but cold, hard cash. The sentiment today is that all debt is bad. The reality, for REITs at least, is somewhere in the middle.

High levels of debt, debt maturity exposure or expensive debt are all considered to be dangerous debt and should be considered red flags, according to John Sheehan, a REIT analyst with Edward Jones. He says most REITs have an average debt to market cap of 30 to 45 percent. “That level of debt doesn't make me uncomfortable as long as it's structured properly and staggered appropriately,” he explains.

It's true that the recent credit crisis (some would say it's ongoing) forced a lot of REITs to the edge. Many had too much debt, or even worse, had too much debt due at one time.

Because REITs own property, the typical REIT had both corporate debt and property-specific debt (mortgage debt). In some cases, REITs had mortgages that were cross-collateralized — meaning that one mortgage was secured by several properties. For example, property A's mortgage would be secured by properties A, B and C. In this scenario, if the REIT didn't pay property A's mortgage, the lender could foreclose on properties A, B and C.

Over the past three years, REITs have deleveraged; in other words, they've reduced the amount of debt they have on their balance sheet. Most of them have also either paid off property-specific debt or refinanced it so mortgages don't all come due at once.

“The general rule is that REITs that have less leverage have provided better risk-adjusted returns,” says Brad Case, senior vice president of research and industry information for the National Association of REITs. “But, low leverage is not a guarantee — you want to look at the kind of debt they use.” (See Red Flag #3.)

Red Flag #3: Limited access to capital

I've renovated a 100-year-old home from top to bottom, and I can promise you that the best handyman is one who has multiple tools in his toolbox and the know-how to use each and every one. The same analogy is true for REITs — the strongest and most successful REITs are those that have multiple sources of capital and an executive team that knows when and how to use that capital.

Historically, REITs have relied primarily on mortgage debt to finance their growth. Increasingly, however, REITs are moving away from mortgage debt (see problems associated with mortgage debt in Red Flag #2) and focusing on accessing capital in other ways.

For example, more REITs are expanding their unsecured lines of credit with multiple capital sources. In addition, many REITs have pursued investment-grade credit so they can issue unsecured debt in the form of corporate bonds. While REIT analysts do not advocate one form of debt over another, they do prefer that REITs have access to capital through many different vehicles.

Red Flag #4: Shaky strategy

REITs are no different from any other business — in order to succeed, they must have a differentiated strategy and be able to execute that strategy consistently and effectively. The problem arises not when they stumble in the execution of their articulated strategy, but when their strategy is ill-defined or shaky. It's even worse when a REIT, faced with a challenging operating environment due to real estate cycles, veers off course.

“You don't want to penalize a company for trying new things and having new ideas,” Sheehan says. “But, if they're changing their strategy every couple of years and chasing the next fad — that's a red flag,” he points out. “Most companies that have been successful have articulated a broad strategy and executed it. Those that haven't been successful have not found their core guiding light.”

Red Flag #5: Excessive executive and board turnover

Unless someone is referring to the entrance of a building a REIT owns, you don't want the word “revolving door” to come up. In fact, when it comes to REITs, job-hopping executives and flighty board members are worse than a red flag, they're a red light, experts warn.

While excessive executive and board turnover can simply be bad timing or family illness, it's more than likely that it is the result of a failure to meet expectations or internal dysfunction. Either way, it's ugly. And, it causes the REIT to suffer from both a lack of quality leadership and continuity.

Without quality and consistent leadership, the REIT's performance could be compromised.

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