What I Wish I Knew Before Buying REITs

[00:00:00]Today I'm going to eat some humble pie and present to you my biggest losers ever, the worst of which lost me 97.7% of my capital. Some of these losses are the result of my own mistake, while others are simply the result of risk factors playing out. I take risk to earn returns and at times it's inevitable that risk factors materialize and I lose some money. There's no free lunch in investing and since I follow a rather aggressive investment strategy seeking to maximize total returns in the real estate category, I will often invest in companies that are heavily leveraged or on troubled assets. If and when these companies manage to fix issues, this can lead to significant multiple expansion and huge upside. A good recent example of that is the mall REIT Macerich, which used to be over leveraged and owned a minority of troubled assets. As the company got rid of those weakest assets and deleveraged its balance sheet, its share price more than quadrupled and we also earned significant dividend income along the way. But not all these investments work out as expected. Often the thesis gets derailed, risk factors play out and up losing some money.

[00:01:01]That's going to be the focus of today's video. Hey, this is Yoel here from my investment firm that specializes in REIT investing and before I get into it, as a reminder, my book The REIT Advantage is now out. So if you want to avoid similar losses when investing in REITs, I think this book could help you a lot. It discusses my entire due diligence process in a five steps, very detailed of how I select my REITs to earn better returns and avoid such losses. Okay, so the first company, which is my biggest loss ever, is Invesco, ticker symbol IVZ. It lost me 97.7% of my money. When I first invested in Invesco before the pandemic, the thesis was quite simple.

[00:01:37]Back then most senior housing REITs like Welltower and Ventas were trading at fairly expensive multiples. However, Invesco was trading at a steep discount relative to its peers despite owning a new build portfolio of senior housing communities that enjoyed very attractive long-term growth prospects. But there was of course a reason for this discount and the main reason was that the company's balance sheet was heavily leveraged with a 60% loan to value. This left room for error, but we were still confident in the thesis because rents were growing at a solid pace in this property sector even as the management has made it priority to work down its leverage. Therefore, we felt that the LTV would likely come back down closer to the low 50s within a year from or two from now. Another reason why the stock was discounted was that its primary listing was in Canada despite owning most of its assets in the US. Moreover, it was not officially structured as a REIT and therefore it was lacking from most REIT indexes. We felt that these two opportunities because both of these issues could be resolved over time.

[00:02:33]Finally, the management had a track record of successful M&A deals. It had sold a previous REIT to Welltower and so we felt that it was quite likely that they were seeking doing the same with Invesco. So overall, the investment thesis seemed very compelling to us.

[00:02:46]Here we had great assets with attractive long-term growth prospects, shareholder friendly management team with a history of M&A deals and yet it was discounted because of the unusual listing, the C-corp structure and the balance sheet, all of which could be improved over time to unlock value for shareholders. But things went horribly wrong shortly after our investments as a result of the pandemic, which turned into a huge headwind for the senior housing industry. Occupancy rates immediately took a dive and cap rates expanded. As a result, property values dropped and the LTV of Invesco shot up and so what was already a dangerously leveraged balance sheet suddenly become way over leveraged. This first forced them into negotiations with lenders. They first worked with them, but eventually this led to a forced restructuring and almost all of the equity value got wiped out.

[00:03:32]In hindsight, it's easy to say today that I held on for too long. I was hoping that the lenders would appreciate that the pandemic was a severe but temporary issue and that they would give extensions to Invesco to work through it and still cover its debt payments.

[00:03:46]Rather, the Invesco took the opportunity to secure the properties to get the equity for themselves. I lost most of my money in the process and really the lesson here for me from this investment and others is that when you're investing in a highly leveraged REIT, you're one black swan away from losing everything.

[00:04:02]And unfortunately, those black swans, while they are unexpected, they will occur regularly over time, whether it's a new war or a recession, a banking crisis, a pandemic. These things are always unexpected as they occur, yet they do happen on a regular basis and therefore it's highly speculative to invest in these type of companies that are just shy of breaching some debt covenants because of over leverage. You know, all it takes is one unlucky event and you lose everything. Taking this into account, I think that the risk reward of my investment in Invesco in 2019 actually wasn't that good and I should have required an even steeper discount to make up for this higher risk. It was a costly but important lesson for me. Second company is Core Energy Infrastructure Preferred Equity, which lost me 89.3% of my capital. This was a REIT that owned energy infrastructure similar to an MLP, but had decided to structure itself as a REIT and I had invested in it knowing that it had quite a bit of leverage, earning steady cash flow from its assets and I decided to strategically invest in the preferred equity thinking that we'd enjoy better margin of safety. I thought that the common equity was quite risky, that dividend could be cut, but I thought that there'd be enough buffer for the common equity to absorb any potential losses and the preferred dividend to keep getting paid in full and on time. I also thought that there was enough asset coverage even if things went downhill, but ultimately I was very wrong. The timing of my investment was of course very unfortunate and partly unlucky, you know, I invested 2021 shortly before interest rates surged at a historic pace and so as a result of this again, we had a dangerous balance sheet become fatal. It became way over leveraged as a result of the rate hikes and this forced the company into bankruptcy. I thought that even in such event, the preferred equity would come out okay out of it. Maybe I wouldn't get all of my preferred equity back, but I thought I would get a big chunk of it as I thought that even the common equity was trading at a discount to NAV, but in reality that didn't happen and the lenders took most of it for themselves only giving a small slice of the new company to the preferred equity holders.

[00:06:04]And that's the lesson here. If you're going to invest in preferred equity, don't make the mistake of thinking that in case of bankruptcy, you're safe simply because you're higher than the common equity. On paper you may enjoy better protection, yes, but in practice from my experience, what typically happens is that the preferred equity holders don't hold any or not much representation in the bankruptcy courts when negotiating with lenders and in the end they end up with close to nothing and the lenders take everything for themselves. Therefore, if there is any doubt of potential distress in a REIT, don't invest in it, not in the common but also not in the preferred equity in my opinion. Actually, if you're going to invest then I'll probably rather invest in the common because at least you would have much greater upside potential if things work out well, but the preferred equity in case of distress has really poor risk reward in my opinion. As for this reason, my preferred equity investments have changed quite a bit over the years. These days I focus more on, you know, companies that have decent balance sheet, decent assets, but for whatever reason I expect their common equity to remain a value trap in the future and I think a good example of that is EPR Properties. I think that its high exposure to movie theaters will make it a value trap as its market sentiment is likely to suffer over time.

[00:07:12]It's going to take a very long time for them to work down this exposure and so I'm not interested in the common equity.

[00:07:17]However, the preferred equity enjoys a very big common equity buffer. This is an investment grade rated REIT, a great track record. They managed to keep paying the preferred equity even through the pandemic, which was the worst possible crisis in the company's history. So I'm very comfortable owning the preferred equity and yet it's trading at a 25% discount to NAV or value, sorry, and offering a 7.1% dividend yield. And so that's a very attractive risk reward in the preferred equity field. Hey, before I go into the third company on today's list, can you please do me a huge favor and click the like button and subscribe to the channel. Helps me a lot to keep on growing. Also, let me know in the comment section below what has been your biggest loser ever. It would be cool to discuss. Okay, this third company is CBL & Associates, which lost me 76.1% of my capital. This was one of my first major public losses as this was a company that I discussed extensively back then many years ago on a platform called Seeking Alpha. I was very publicly bullish on it. Back then the REIT was trading at what seemed like a huge discount to its net asset value, trading at a 50% discount and it was offering a 10% dividend yield with a seemingly low payout ratio of just 50%.

[00:08:19]I knew of course that the REIT owned class B malls and so I didn't expect much if any growth from them over the long term, but I still thought that the market had over reacted to the threat of e-commerce not understanding that class B malls in many cases are similar to class A properties but simply in secondary or tertiary markets. But they're still typically the dominant mall that's doing well. The assets of CBL back then were earning record high sales per square foot despite e-commerce already being a really big thing and clearly they were not dying because of e-commerce. CBL was also actively reinvesting in its properties to make them more desirable, to diversify uses, to have non-retail uses such as entertainment, restaurants, even some office space in some cases, some medical uses. And so that was making its properties more resilient. I also thought that as e-commerce eventually hurts some of the weaker malls, those malls would close down leading to traffic consolidation towards the market dominant malls, which CBL owned in many cases. So what went wrong? And it's one simple thing. I under appreciated, under I misunderstood the CapEx of CBL. You know, I thought that most of its CapEx was discretionary growth CapEx reinvesting in its properties to make them more valuable, to result in greater cash flows. But in reality, a lot of this CapEx really wasn't that. It was maintenance CapEx that was required just to keep the properties afloat and without these CapEx investments, the story would collapse very quickly. And so then when the pandemic hit and suddenly the company was not able to make all these CapEx investments because tenants were not paying their rent, things went downhill really quickly. The company was was also more heavily leveraged than I previously thought, again because of this capex. You know, if you had adjusted the cash flow to FFO for the capex, it would have been quite a bit lower, meaning that the payout ratio was higher than it seemed, the leverage was higher than it seemed, and yes, the pandemic was just way too much for the company. This forced it into bankruptcy. Fortunately, I had made the lucky decision to switch from the common equity to the preferred equity shortly before the pandemic. That was partly luck, and so because of that, I didn't lose 100% of my investment, but still lost most of it. 76%. So, yes, pain painful loss, but this also taught me an interesting lesson on on malls, which later allowed me to have conviction and invest very heavily in Macerich, which has more than quadrupled from its low.

[00:10:37]So, you know, sometimes these losses can also turn into very profitable future investments as you learn from them. Now, I today hold about 22 REITs in my portfolio, which have all been cherry-picked based on the the strategy that I discussed in my book, and if you want to access my full REIT portfolio, you can join High Yield Landlord for a two-week free trial. There will be a link in the description of this video.

[00:10:59]Thank you very much for your support.

[00:11:00]See you at my next one. Bye-bye.