Real estate investment trusts (REITs) can be great investments. Over the long term, REITs have historically outperformed the stock market with less volatility. Meanwhile, some REITs have made their investors very rich.
However, not all REITs are good investments. Many have underperformed the stock market, while some have been big losers. Here are three common mistakes REIT investors make that could lead to them getting themselves into a poorly performing investment.
Chasing after yield
One of the main draws of investing in REITs is that they pay above-average dividend yields. However, some REITs pay much higher dividends than the sector’s average. While those bigger payouts might be tempting, they can be a warning sign that a REIT’s dividend isn’t sustainable. These are sometimes called yield traps.
So investors should avoid buying a REIT solely for its yield. Further, when a REIT offers a higher dividend yield, it’s crucial to take a closer look at the cause. In some cases, it’s because the REIT trades at a low valuation. However, some REIT dividends are high due to an elevated dividend payout ratio. If a REIT’s dividend payout ratio approaches 100% of their FFO, it’s a warning sign the dividend isn’t on solid ground. While the dividend might survive, there’s a higher risk of a payout reduction in the future.
Not understanding how a REIT makes money
Most REITs lease space to tenants under long-term agreements. That enables them to generate relatively stable rental income even during economic downturns.
However, not all REITs operate this way. For example, hotel REITs rent rooms to travelers under very short-term agreements. So when the economy hits a rough patch, hotel occupancy levels and room rates plunge. That was the case during the pandemic in 2020. As a result, most hotel REITs tumbled in value and suspended their dividends.
Timberland REITs, mortgage REITs, self-storage REITs, and some healthcare REITs also have more variability in their income streams, which means their dividends and stock prices can be much more volatile than other REITs.
That’s why an investor must understand how a REIT makes money. That way, they know what they’re getting into before investing in that company.
Failing to fully evaluate a REIT’s portfolio
Another common mistake investors make is not understanding what’s in a REIT’s portfolio. Property concentration, location focus, and tenant quality are all essential factors investors should evaluate.
An investor might want to buy an industrial REIT to play the fast-paced growth in e-commerce that’s driving demand for warehouses. However, industrial real estate is a broad category, including warehouses, light manufacturing plants, cold storage facilities, and other properties. So an investor needs to take a close look at a REIT’s portfolio to make sure it holds the type of real estate they want to own.
For example, STAG Industrial (NYSE: STAG) owns a diversified mix of industrial properties, including warehouse buildings and light manufacturing facilities. Meanwhile, Americold Realty Trust (NYSE: COLD) owns cold storage facilities, PS Business Parks (NYSE: PSB) concentrates on multi-tenant industrial parks, and Innovative Industrial Properties (NYSE: IIPR) owns medical-use cannabis facilities.
It’s also vital to know a REIT’s tenant focus. For example, some office REITs focus on leasing properties to very stable government agencies, others concentrate on technology companies, and still others aim for a diversified mix. Meanwhile, some retail REITs concentrate on freestanding properties triple net leased to essential retailers with investment-grade credit. In contrast, others own regional malls or shopping centers filled with financially weaker apparel retailers. These different tenant focuses can impact a REIT’s rental collection rate during an economic downturn.
Finally, some REITs focus on specific geographies. Location has proven to be a differentiator for residential REITs, as those concentrating on the fast-growing Sun Belt region have thrived during the pandemic. On the other hand, those focused on major coastal gateway cities have struggled.
Given the importance of a REIT’s portfolio, investors need to take a close look at what type of properties a REIT owns, its primary tenant focus, and its location concentration, because these factors can significantly impact its performance. Investors should avoid REITs that own properties in regions in decline or leased to tenants facing headwinds. Instead, they should focus on those where the fundamentals are healthy.
The Millionacres bottom line
REITs can be great wealth-creating machines. However, not all REITs will create value for investors, which is why they need to do some due diligence before adding to their portfolio. That will help them avoid common mistakes like chasing yield, buying a REIT with a volatile income stream, or investing in one with a lackluster portfolio, which can cause underperformance.
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