Sunday, June 11

Week 310 - The 9 Largest Equity REITs In The US

Situation: Our ITR blog encourages investors to plan for retirement by favoring stocks that have low price volatility because of being issued by high-quality companies with low debt. To measure quality, we look for Dividend Achievers having an S&P bond rating of BBB+ or better. To document “low debt”, we require that Long-term Debt be no greater than 1/3rd of Total Assets, Tangible Book Value be a positive number, and dividends be paid out of Free Cash Flow. For added safety, we focus on companies with sufficiently high revenue to be on the Barron’s 500 List, and are well enough established to have their 16-yr trading record analyzed by the BMW Method. Yes, our approach has technical details but only enough to put Warren Buffett’s principles of stock-picking into practice.

Now we’ll try to use this introduction to show that there is some value to be found by investing in the leading “alternative” asset class: equity real estate investment trusts or REITs. These capture the benefits and risks of owning real estate, but trade like stocks. 

Mission: Examine the 9 largest US Equity REITs by market capitalization. Introduce the unique features of equity REITs, and carry out our standard spreadsheet analysis.

Execution: see Table.

Administration: Read no further if you’re paying down a home mortgage. Why? Because you’re already more heavily invested in Real Estate than you should be, i.e., approximately 15% of your Net Worth. Real Estate is a gamble. Most of us want to own our own home but there is less risk in owning an REIT (or an REIT index fund) than owning a home. If you’re still reading, I assume that you live in a rental and need to own shares of an REIT to diversify your portfolio. In other words, you’re looking to add an income-producing asset that tracks neither the bond market nor the stock market. In terms of investment jargon, you’re seeking alpha: “alpha is the return on an investment that is not a result of general movement in the greater market.” 

A popular way to attempt this feat is to own gold but gold has storage costs and produces no income. There are other “alternative investments” but, like gold, they’re all riskier to own than either a stock index fund like the Vanguard Total Stock Market Index Fund (VTSMX at Line 23 in the Table) or an investment-grade bond market index fund like the Vanguard Bond Market Index Fund (VBMFX at Line 17), or even an REIT index fund like the Vanguard REIT Index Fund (VGSIX at Line 21), which of course lost more than VFINX during the 4.5 year Housing Crisis (see Column D in the Table).

REITs are structured to have investors pay at least 90% of the taxes, in return for receiving at least 90% of the rental payments. REITs have considerable property value and borrow heavily against that Tangible Asset. They also have different accounting conventions:

When evaluating REITs, you will get a clearer picture by looking at funds from operations (FFO) rather than looking at net income. If you are seriously considering the investment, try to calculate adjusted funds from operations (AFFO), which deducts the likely expenditures necessary to maintain the real estate portfolio. AFFO is also a good measure of the REIT's dividend-paying capacity. Finally, the ratio price-to-AFFO and the AFFO yield (AFFO/price) are tools for analyzing an REIT: look for a reasonable multiple combined with good prospects for growth in the underlying AFFO.” 

For comparison purposes, we’ll examine McDonald’s Corporation (MCD). Most of its income is derived from rents that are paid on the 82% of its properties leased to franchisees.

Bottom Line: Whenever you venture into owning an “Alternative Asset”, you’re likely to feel some symptom of stress. That’s because you’re gambling with hard-earned cash. While REITs are the safest of alternative assets, you should carefully pick one or two because simply owning an index fund of REITs does not offer enough reward to make up for the risk. In this week’s Table, we drill down on the 9 largest REITs and find that all but these two are unacceptably risky: Public Storage (PSA) and Simon Property Group (SPG), at Lines 3 and 5 in the Table. Otherwise, you’re better off investing in McDonald’s (MCD), which gains the lion’s share of its income from rents and has a risk/reward profile similar to REITs.

Risk Rating: 7 (where 10-Yr US Treasuries = 1, S&P 500 Index = 5, and gold bullion = 10)

Full Disclosure: I own stock in SPG, TIREX and MCD.

NOTE: Metrics are current for the Sunday of publication. Red highlights denote under-performance vs. VBINX at Line 20 in the Table. Purple highlights denote Balance Sheet issues and shortfalls. Net Present Value (NPV) inputs are described and justified in the Appendix to Week 256: Briefly, Discount Rate = 9%, Holding Period = 10 years, Initial Cost = average stock price over the past 50 days (corrected for transaction costs of 2.5% when buying ~$5000 worth of shares). Dividend Growth Rate is the 3-Yr CAGR found at Column H. Price Growth Rate is the 16-Yr CAGR found at Column K ( Price Return (from selling all shares in the 10th year) is corrected for transaction costs of 2.5%. The Discount Rate of 9% approximates Total Returns/yr from a stock index of similar risk to owning shares in a small number of large-cap stocks, where risk due to “selection bias” is paramount. That stock index is the S&P MidCap 400 Index at Line 28 in the Table. The ETF for that index is MDY at Line 19. For bonds, Discount Rate = Interest Rate.

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