Editor’s Note: As longtime readers know, Brad regularly lectures at universities across the country. He was recently invited to Georgetown to speak on the importance of properly valuing REITs. Read on for a lightly edited portion of that lecture.
Good evening.
My name is Brad Thomas, and I’m happy to be back guest lecturing today. It’s always a pleasure to be here on the great Georgetown University campus.
I want to discuss how to value real estate investment trusts – or REITs. These aren’t the most talked about assets out there, but I believe the investing world would be a better place if they were.
Let me explain…
Most REITs are physical-land-holding, space-leasing, rent-receiving companies with dozens, hundreds, or even more than a thousand properties in their portfolios.
They’re also dividend-paying companies, which is a great feature to begin with. But these particular dividend-paying companies come with a bonus: a unique structure where they have to pay out most of their net income to investors.
Unlike traditional dividend-paying stocks, REITs are required to distribute at least 90% of their annual taxable income to shareholders. That makes their value proposition especially attractive, offering investors higher dividend yields as a general rule.
Today’s average REIT dividend yield is around 4.5%. That’s significantly higher than the average yield for the S&P 500.
Which is a measly 1.3%.
This dividend superiority has produced a steady stream of income from the sector. Because REITs have to pay out so much of their intake, that leaves a lot less room for them to be foolish with their money.
The result tends to be steady stock and dividend growth that leads to safe but significant wealth accumulation. When handled intelligently, that is.
I do want to make it clear that REITs, despite all their attractive attributes, aren’t perfect. While they are typically less risky than other stock categories, they can fall or even fail.
That’s why knowing about REITs is a great first step toward setting up a superior, properly allocated investment portfolio. But it’s not the only one.
You also need to know how to select the right companies.
Selecting the Right Companies by Avoiding the Wrong Ones
Avoiding bad investments is every bit as important as choosing good investments in general. And that rule applies just as much to REITs as any other asset out there.
So it’s important to recognize that otherwise good companies can, at times, be poor portfolio holdings. They can have great management teams, great positioning, and great customers…
But then disaster strikes through no fault of their own.
Some immediate examples that come to my mind are office and hotel REITs, which suffered immensely during the lockdowns. And those problems keep playing out today, making not just their share prices but also their dividends more risky.
There are also examples of businesses that are just poorly run.
Take Gladstone Commercial (GOOD), a net-lease REIT with a poor history of dividend growth. It hasn’t increased its dividend in over 10 years and, in early 2023, actually cut that payout by a whopping 20%.
Many shareholders suffered as a result.
Fortunately, my readers who followed my advice weren’t among them. My team and I knew the dividend was vulnerable because we knew the warning signs to look for.
We consider several factors, including a company’s earnings and dividend history, the overall strength of its balance sheet, and its dividend safety.
None of which put Gladstone in a good light. As I wrote in December 2022, weeks before the REIT cut its dividend:
This earnings profile is as flat as a pancake! Why would you want to invest in a company that’s not growing?
Worse still, I added, its payout ratio was extremely elevated. Put simply, it was putting too large a percentage of its finances toward maintaining its dividend. There was barely enough left to cover its normal business expenses.
If anything unexpectedly negative happened – even a minor complication – that dividend would have to be cut to pay for it.
Sure enough, early the next month, Gladstone cut its dividend and its shares fell on the news. In fact, since I wrote that article in December 2022, those shares are down 26%.
And I don’t see them rebounding any time soon.
Getting to the Good Stuff
By saying no to bad opportunities like Gladstone, we’ve got more room to fill with quality holdings like Digital Realty (DLR).
DLR is a leading REIT that owns over 300 data center facilities around the globe. Its revenue stream comes from very large, stable companies like Oracle, IBM, LinkedIn, Meta, AT&T, and Verizon, just to name a few.
They store their digital information there. DLR keeps it from getting corrupted.
Combine that business model with wise management members who know how to put DLR’s profits to good use and manage its debt appropriately. That’s how you get a healthy, growing REIT and therefore a healthy, growing dividend.
Once you find that kind of gem, you next need to make sure it’s affordable. This doesn’t mean you have enough money to buy it, for the record. It’s whether that money will be well-spent.
Or, to put it another way, you need to be confident you’ll make more money than you put in. Often, this means taking advantage of someone else’s foolishness.
Maybe other investors are ignoring a rising opportunity. Or maybe some negative press emerged that everyone overreacts to.
A pretty dramatic example of this is my Digital Realty recommendation in 2022. Hedge fund king Jim Chanos decided to short the REIT because he believed the business it was built on was unsustainable.
All those big companies that stored their data with DLR and its competitors, he said, would decide to build their own facilities instead of leasing.
It was a ridiculous premise to begin with, made even more so with the continuing rise of data-intense artificial intelligence. Why would enough corporations take on such a giant project – including all the exceptionally specific details necessary to construct and maintain that data – when they could continue trusting the experts to do it instead?
As it turns out, they wouldn’t. That was my counterproposal, which I had no problem writing about.
It ultimately allowed me to boast a bit on X just the other day:
That’s what happens when you know that the key to creating wealth is based on both quality and value. You get to put the odds in your favor over and over again.
You’re never going to have a perfect track record. Nobody knows everything, and everyone makes mistakes.
But what I do know – what I’ve put into practice and seen for myself for years and years – is that it pays to hold the right REITs at the right price.
Regards,
Brad Thomas
Editor, Intelligent Income Daily