How To Invest In REITs – Pros, Cons And Simon Property Group Example Analysis

Content:

How To Invest In REITs – Pros, Cons And What Are REITs
Introduction – REITs have been the best investment over the last two decades
What impacts REITs as investments – dividends and capital appreciation
Pros and cons of investing in REITs
The pros of REITs
The cons of investing in REITs
Simon Property Group REIT analysis (NYSE: SPG)
SPG company overview
Densely populated areas and high demand lead to positive lease spreads
Dividend is just 65% of funds from operations but still yielding 5%
Self-funded growth and investments
SPG’s debt
The retail environment in the coming years

This article is about the general pros and cons of investing in REITs and about Simon Property Group (NYSE: SPG), used as an example to show what to look at when investing in REITs.

Introduction – REITs have been the best investment over the last two decades

REITs (Real Estate Investment Trusts) have been the best performing asset class in the last 20 years with an average return of 9.9%. This much better than the 5.6% return of the S&P 500 and even better than gold or oil.

investment returns.PNG

Source: Raymond James

The most important point to note is that despite the S&P 500 returned 5.6% per year, the average investor got a return of 1.9%. This really emphasizes Graham’s statement:

“The investor’s chief problem — and even his worst enemy — is likely to be himself.”

Buffett always suggests to read chapter 1, chapter 8 and chapter 20 of Benjamin Graham’s book The Intelligent Investor (full summaries in the links) to avoid making the mistakes average investors usually make, which is to buy high during exuberant times and sell low in panicky times. I know some that sold in March of 2009 and bought back only in 2015. Nevertheless, this is not a story about investment mindset on which you already have the links to Graham’s book above, this is a report on whether it is smart to invest in REITs now and whether we can expect a similar performance in the next decade or two. In this article we will discuss:

  • Why did REITs do that good
  • What impacts REITs as investments – dividends and capital appreciation
  • Pros and cons of investing in REITs
  • Put all into perspective by analysing Simon Property Group (NYSE: SPG)

The goal of this article is to check whether it is smart to invest in REITs now, compare the possible rewards to the risks and avoid being the average investor, as average investors will again underperform almost anything else over the long term.

Why did REITs do that good over the past 20 years?

The main reason REITs did good are interest rates. In 1999, from when the previous chart measured performance, interest rates have gone mostly down.

interest rates REIT.PNG

Source: Raymond James

In 1999, you would get $6,000 on $100,000 in a normal savings account while during the last years, you would get less than $1,000.

However now, some cash investments accounts do generate around 2% as interest rates increased. Consequently, REITs did extremely well up to 2016, then as interest rates started going up, then there was a bit of a pause due to the FED making a few hikes, but since Powel capitulated on higher interest rates, REITs resumed their growth.

reit investment returns

Source: iShares Core U.S. REIT ETF

The above clearly indicates that REITs are interest rate plays. If you can get a 6% return on government guaranteed savings, you are going to expect a much higher yield from various real estate investments that are always risky.

However, real estate investments, unlike bonds, offer inflation protection as the value of the properties might go up in the future and you can increase rents, thus some REITs should even deserve a premium. Additionally, REITs usually borrow money to acquire real estate or mortgage backed securities and thus interest rates play two roles. One comparative for investors that we just explained and the second for their margins as the higher the interest rate spread, the higher the profits of the REIT. The interest rate spread is the difference between the interest the REIT is paying on the loan and the yield on the mortgage backed security it bought, for example.

The iShares Core U.S. REIT ETF has a yield of 3.5%. If investors would suddenly expect a yield of 7% because of a higher interest rates environment, the value of REITs would probably half.

4 reit yield.PNG

Source: iShares Core U.S. REIT ETF

One might look at the above 3.5% yield and say no way because it is too low, but we don’t invest in markets or indexes, we invest in individual businesses and therefore we must look at individual opportunities. Plus, REITs are not only about dividends.

What impacts REITs as investments – dividends and capital appreciation

Many focus on dividends as the only return metric for REITs. However, investors can expect returns in the form of capital appreciation too. If you can increase rents, the value of the underlying real estate will probably go up in the future. Plus, as the targeted inflation rate is above 2%, we can add a minimal 2% yearly dividend return that we can expect from capital appreciation.

This is also what I am going to focus on while researching REITs:

  • First, we have the dividend that is paid out of the REIT’s funds from operations (FFO).
  • Second, if the dividend is smaller than the FFO, it means that the REIT has space to self-fund its growth, that should add too to the investment picture.
  • Third, given the huge money printing over the past decade and likely increase in the future, I think there is a high chance of high single digit inflation where owning good real estate comes in handy.

Let’s summarize the pros and cons of investing in REITs and start this REIT overview by looking at the largest position of the USRT REIT, Simon Property Group (NYSE: SPG). The stock is close to its 52-week lows, offers a 5% yield, so it looks like a good start to understand the sector better.

1 spg stock.PNG

Pros and cons of investing in REITs

The pros of REITs:

  • You can own real estate without the hustle of repairing toilets

Real estate investment trusts are internally self-managed or externally managed vehicles that take care of real estate for you; collect rent from tenants, pay expenses and give you what is left in the form of dividends. There two main types of REITs; equity and mortgage REITs. Mortgage REITs invest in mortgage backed securities while equity REITs invest directly in real estate.

Further, you have many various specialized REIT like land REITs, apartment, senior housing, single family, hotels, retail, commercial, offices, healthcare, storage, data centres, industrial, timberland and many other specializations. There is a REIT for practically anything related to real estate and those that do more are called diversified REITs.

  • REITs have to pay out at least 90% of income through dividends and pay no income tax

REITs are especially attractive to income seeking investors as more than 90% of income has to be paid out in the form of dividends. If not, a REIT might lose its REIT status which also brings the benefit of no corporate income taxes. Therefore, payments to shareholders can be substantial, especially over time.

Finding the REIT that manages to grow, have a higher yield from the invested properties than the cost of capital and thus the capacity to increase dividends, is the holy grail of investing in REITs. We are going to do out best to find REITs that have the potential.

  • Real estate usually appreciates in value and offers inflation protection

Apart from the above-mentioned dividend and income, REITs can offer huge returns from capital appreciation. If there is inflation and you own real estate while you have long term debt with fixed interest rates, you would be in REIT heaven. (we already used the holy grail anecdote so heaven is better here). REITs can simply increase rents or hotel room prices if there is inflation. Of course, if the property offers quality.

The key is to hold those REITs that will continue to see the value of their real estate appreciate. Empty malls, ghost cities or abandoned factories are definitely not a good sign for capital appreciation.

  • Liquidity

Even if liquidity should not be a concern for long term investors, you can sell your REIT by on click on your mouse. Something you can’t do when you own real estate.

The cons of investing in REITs:

  • Interest rate risk

We already mentioned how REITs depend on interest rates as lower interest rates have been a key factor in their boom. However, if a REIT is a great business, has great properties and a good business model, you shouldn’t worry much about interest rates as lower REIT stock prices would allow you to increase your yield on the reinvested dividends and consequently your long-term returns.

  • REITs use a lot of leverage

As REITs have to pay out more than 90% on their income there isn’t much left for growth. As ‘no growth’ is practically the most hated situation on Wall Street, managements tend to do whatever it takes to keep growing which includes risky acquisitions or mergers, overinvesting in new properties even if the market is saturated and not having a margin of safety within the interest rate spread.

  • There is high competition

Investing in real estate is like investing in stocks. As would Peter Lynch say, the more stones (stocks) you turn, the number of great investments you find will be larger. You can check my video on How to invest in real estate here if you wish to hear my views on what makes the difference when it comes to investing in real estate.

However, REITs usually invest in large properties, there are usually many bidders for such projects and, especially if the property is of high quality, initial investment prices can be sky high. Therefore, by investing in REITs you miss on the opportunity to really find the best bargain in the neighbourhood or a fix-up that doesn’t really need that much work but others don’t see it. Such laser focused real estate investing allows you to make money immediately when you buy as you pay less than what the property is actually worth.

Some REITs trade below net asset value but there is usually a reason for that, it can be the management, trends, new competition etc.

  • Most people already own a home

By owning your home, you are already exposed to many of the real estate benefits mentioned, especially if you have a low interest rate 30-year fixed mortgage. Therefore, having a heavily weighted REIT portfolio alongside owning a home and maybe a rental unit, might make you too exposed to the real estate market that, as we have seen from 2009 to 2013, doesn’t always go up.

  • The dividends are taxed as income

Taxes are always personal but you have to check how will the dividends you receive from REITs be taxed or you might want to hold REITs in non-taxable accounts. This is an even bigger mess for non-U.S. investors.

  • Some real estate sectors are being hit hard, think of retail

Given the boom in e-commerce, retail is hit hard and consequently REITs owning retail stores suffer. On the other hand, REITs owning distribution centres do well, so be careful when buying REITs and either buy absolute bargains or REITs that have strong sector tailwinds.

  • REITs were created in the 1960s and boomed only in the last 30 years

The first REITs were created in the 1960 while REIT investing became really popular only in the last few decades. Therefore, you might be buying in exuberance as average investors usually flock into buying exuberantly priced assets after the low risk/high return gains have already been made.

  • The risk of a recession

When discussing almost any business, you will hear how it would be impacted by a recession. REITs would be no exception but perhaps investors still have a bit too much of 2009 in their memories. Further, as we can’t anticipate a recession, perhaps it is best to simply know your portfolio will suffer, at least temporarily, reinvest the dividends and enjoy the ride up when the recession is over. Therefore, yes, earnings might fall and dividends might get cut, but that is with every business and many didn’t invest in 2010 fearing a recession. No need to mention how they feel now.

Let’s now put all the above into perspective by analysing a very large REIT, Simon Property Group.

Simon Property Group REIT analysis (NYSE: SPG)

I want to start this REIT analysis series by analysing one of the best REITs out there, Simon Property Group (NYSE: SPG). I’ll also use it to explain what you need to know when investing in REITs:

  • The dividend yield, buyback, growth and capital appreciation return
  • The interest/lease spread
  • Funds from operations (FFO or AFFO – adjusted)
  • Focus on debt
  • Sector trends

SPG company overview

SPG owns malls and outlets in the US, Europe and Asia.

SPG REIT mall.PNG

Source: SPG – The Shops at Crystals, Las Vegas NV

I am going to focus on the key aspects of investing in SPG and avoid a purely descriptive chapter as you can learn much more about the business from their Investor Presentation. Just shortly, 79.5% of net operating income comes from U.S. malls and outlets, 11.7% from the Mills, a REIT they acquired in 2007, and 8.7% is international.

2 overview spg.PNG

Source: SPG

The key factors for SPG are the following:

Densely populated areas and high demand lead to positive lease spreads

Despite the turmoil in the retail sector, SPG keeps increasing rents and keeps occupancy at high levels. Average leases per square foot increased from $51.59 in 2016 to $54.18 in 2018. If a company can increase rents and keep a high occupancy rate, it means their customers aren’t really in that much trouble.

The lease spread is the difference between the new lease in comparison to the lease of the previous tenant.

3 leases going up.PNG

Source: 2018 Annual Report

SPG is considered a high-quality REIT, with great assets and therefore it can increase leases.

Dividend is just 65% of funds from operations but still yielding 5%

Funds for operations (FFO) is a crucial metric when it comes to analysing REITs. FFO describe what is left after all the expenses are paid. The management has to distribute more than 90% of net income as dividends but don’t forget that a non-cash expense when owning real-estate is depreciation. Thus, the cash flows are usually higher than net income. Therefore, SPG can self-finance its growth as it is practically distributing only 65% of what it could distribute. This leaves room for buybacks and investments on top of the 5% dividend yield.

4 distribution.PNG

Source: 2018 Annual Report

In February 2019 SPG announced a new $2 billion dollar buyback program for 2019 and 2020. If they spend all the available $2 billion on buybacks, that would add a 1.7% yearly buyback return to the dividend as the market cap is currently $57 billion. This would put the expected investment return to 6.7% already. But that is not all, there is still room for growth.

Self-funded growth and investments

The company is building new developments and refurbishing existing malls.

5 investments.PNG

Net operating income growth was 3.2% in 2018 and 4.2% on average over the last 4 years (this includes inflation). Even if we put a conservative 3% growth rate on net operating income, the growth should increase income by 80% over the next 20 years that should consequently add another 3% to the return from SPG.

Summing up the 5% dividend, 1.7% buybacks and 3% growth, the expected yearly return from SPG could be 9.7% over the next decade or two.

SPG’s debt

When it comes to debt, SPG is as good as it gets with A credit ratings. This means that whatever hits the economy, SPG should not have trouble to service its debt payments.

8 debt.PNG

Source: Investor Presentation Q1 2019

The only thing that is concerning a bit but it might also be a management decision, is the shorter debt maturity. This is necessary to keep the same interest rates as the cost of debt went up over the past years, but longer fixed interest rates are always nicer.

9 credit profile.PNG

Source: Investor Presentation Q1 2019

Logically, SPG has most of its debt on fixed interest rates.

10 fixed.PNG

Source: Investor Presentation Q1 2019

What is really interesting are the interest rates in Europe. The Noventa di Piave designer outlet close to Venice, where I have been once when returning from a visit to Venice and Padova, has a fixed interest rate of 1.95% maturing only in 2025. This implies SPG might easily grow in Europe as interest rates are ridiculously low.

11 europe.PNG

Perhaps there will be other acquisitions. As long as the net operating income is higher than the cost of capital needed to service the acquisition debt, it pays to growth via acquisitions. This might add another percentage point to the returns over the long term.

6 presenation.PNG

However, there is always a catch.

The retail environment in the coming years

This is the main question to answer when it comes to retail REITs, are these outlet centres going to still be interesting to consumers in 5 to 10 years? Or, will we be so entangled into virtual reality that a visit to an outlet or mall will be considered a waste of time?

The answer to the above questions is unknown, some may be more or less convinced but the reality is nobody knows what the future brings. As investors we have to think about what can happen and then put it into an investing perspective.

Things could continue as those are now, thus SPG should continue to pay a 5% yield that should probably grow between 3% and 5% per year, the company should continue to do buybacks and the expected return should be close to 10% per year.

E-commerce might even boost SPG’s growth as omnichannel might lead online sellers to open stocks in high-end locations.

However, if there is less interest for malls and outlets, revenues might stagnate and consequently eliminate the additional 3% yearly return coming from growth. SPG owns class A malls and outlets while market specialists predict closures for class C and D malls. Mall bankruptcies might even increase the number of visitors for SPG.

Another risk is always interest rates, if interest rates go up, SPG’s spreads might decline.

I think the above described uncertainty is what the market is pricing in because if not, you wouldn’t find a high-quality REIT like SPG offering a 10% total yearly long-term return.

I am going to continue to look at REITs and at the end of the sector analysis we are going to compare what is out there and perhaps find something to watch or even invest in. The fact that one of the largest REITs in the U.S. possibly offers 10% is encouraging for further REIT research.

reit comparison dividend.PNG

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You can retire by investing in the stock market – just don’t invest like everybody else in index funds

  • It is possible to retire earlier using the stock market if you focus on investing in businesses. Investing is all about business earnings and value.
  • This paper will show how historically, you can do amazing things if you think before you invest, or at least avoid the stupid mistakes others usually make. When it comes to retirement, small current mistakes are extremely costly in the long term. 
  • I’ll give you an example of a simple stock that has been paying a dividend for 89 years and will likely outperform most indexes. I’ll also add 5 stock ideas. If you find 20 of such stocks, you practically need nothing more for your retirement.

Financial independence and retiring is the goal of many investors. This booklet will cover current and future potential investing opportunities and strategies that will help you achieve your financial goals in the long term. To achieve financial independence sooner, with more certainty, one has to invest in investments that offer less risk and, at the same time, higher returns than other investments – this is called value investing.  

Financial independence topics covered are:

  • Stock market and retiring – great tool but use it smartly!
  • The economy, inflation and your financial independence
  • Real estate – the best leverage, diversification and inflation protection option.
  • A fixed vs. a dynamic investment mindset – over decades, things change.
  • Diversification, yes, but not like and when your banker advises.

In this article: 

Contents

  • Stocks can make you financially independent – but mind the valuations, value, business strength and risks
  • The value investing truth – buy businesses with value
  • PE ratio and price to book value
  • Value investing – Margin of safety
  • Current value and strong earnings example plus 5 stocks to watch
  • How can you find such stocks?

Index funds might not be the vehicle to your financial independence

The predominant investment advice you hear is to invest your money in index funds, usually the S&P 500 (SPY). Invest on a monthly basis and simply forget about it. 

That is a good advice, unfortunately it is better suited for the 1980s or 1990s than now. Nobody can argue that stocks have been an amazing investment over the past 35 years. Those that invested $1,000 in the S&P 500 in 1982, have now $26,000 and the dividend is $480 per year. Not bad on a $1,000 investment. Those that invested $100k in 1982, have now a dividend of $48k per year and a capital of $2.6 million. I would call that a wonderful retirement scenario.

pastedGraphic.png

Source: Macrotrends

The problem is that back then, really few dared to invest in stocks. Even investing legends, like Ray Dalio, didn’t invest in stocks in 1982. Actually, stocks looked that bad that Dalio was betting against stocks and practically lost it all. 

pastedGraphic_1.png

Source: Business Insider

Fast forward 35 years, and you can practically hear everybody discussing how index funds or ETFs are the best way to invest. I agree those have been the best way over the last 35 years, but I argue the same will not be true over the next 35 years. You cannot expect to invest $100k in the S&P 500 today and up with millions in 30 years simply because stocks were cheap back then and now stocks are expensive. Nevertheless, the best way is to still invest in stocks, but as in 1982, the best way is usually not to copy what the herd does.

The value investing truth – buy businesses with value

Let me tell you the little truth Buffett and other value investors like Seth Klarman use, the simple mindset that pushed Buffett to crazily buy stocks during the 1982 period while others, like Dalio, were selling.

Warren Buffett and other value investors focus on business earnings and the price paid for those earnings. To quote Seth Klarman from his book Margin of Safety:

pastedGraphic_2.png

The thing that makes investing simple is understanding the investing law where long term investment returns are perfectly correlated to the performance of the underlying business. This means that when investing, one should focus on investing in good businesses, not stocks. Stocks are extremely volatile; good businesses simply continue doing business no matter what. In a good year most make good money, in bad years a little bit less and that has been the case since humanity.

The investing core around what your focus should be is that business earnings will determine your long-term returns and those are what you should care about when planning retirement or financial independence. 

Another thing mentioned by Klarman is value, there is a difference when investing in agricultural real estate the produces a healthy yearly yield and in stocks that offer mining cobalt in an African country. With the latter anything can happen while with value, you know you buy value. To quote Buffett:

“Value is what you get, price is what you pay”

Retirement is too important to bet it on promises from companies like Tesla, Lyft, Uber etc. Those might succeed, but if those fail, so does your retirement. I wouldn’t consider such stocks an investing option.

PE ratio and price to book value

The two best approximate indicators of business earnings and value are the price to earnings (PE) ratio and the price to book ratio. The price to earnings ratio simply divides the price, i.e. what you have to pay, with the underlying earnings a business delivers. The result is your business earnings yield, your long-term investment yield.

The S&P 500 mentioned above, has a PE ratio of 22 that leads to an earnings yield of 4.5%.

pastedGraphic_3.png

Source: Multpl

Approximately 4.5% is what long term investors can expect when investing in an index like the S&P 500. Perhaps even a bit higher as earnings will grow in the future alongside economic growth. I would say 4% to 6% is what you can expect. It is not bad, but there are some risks one has to consider when making a retirement strategy.

The first risk is the S&P 500 earnings yield of just 4.5%. If we look again at the above chart going back to 1871 based on professor Shiller’s data from Yale, the average historical yield was 7.36%, in line with what has been the average historical return from stocks. The problem is that if in 10 years, the required return from stocks is back to 8%, like it was in 1990 and for the most part of history since we have stock market data, investors would actually look at miserable returns over the coming 10 years. Miserable returns are something that doesn’t help with retirement and those are not uncommon when it comes to investing. We have to always expect that one can look at negative real returns over one or two decades.

pastedGraphic_4.png

Source: Macrotrends

Of course, one would say there are always the dividends, but in 1929, 1966, 2000 and 2019, the dividend yield was 3.3%, 3%, 1.5% and is 1.8% respectively. Thus, if stocks go nowhere for the next 20 years, you can count only on a dividend yield of 1.8%. For me personally, this is a big risk that can be avoided by buying investments that offer a higher yield for the same risk or even lower risk. 

Also, you cannot tell people in The Netherlands or Croatia that stocks always go up. The Dutch AEX index is still 18% below its 2000 peak. Fortunately, it is higher than the 2002 and 2009 lows that represented 70% declines. 

pastedGraphic_5.png

In Croatia, stocks are still 75% below their 2007 peak.

pastedGraphic_6.png

Source: Trading Economics

How to know when to buy in order to catch the upside and avoid the huge downside shown above? Look at valuations (business earnings in relation to price) and book value. The Dutch and Croatian markets had crazy valuations in 2000 and 2007 while the PE ratios were low in 2009. Given the above, I wouldn’t bet most of my retirement on any index just because it might have worked for some in the past. It doesn’t mean it will work for me now. It might work, but it also might not given the current valuation compared to historical parameters, too much of a risk when it comes to retirement.

Starcapital has excellently summarized what you can expect when looking at business earnings. To even out cyclical influences they have used the 10-year average PE ratio, the so-called CAPE ratio (cyclically adjusted price earnings). As the current CAPE ratio of the S&P 500 is 30, investors cannot expect great subsequent real returns. The average return can be expected to be around 5%. This is again not bad, but could always be better.

pastedGraphic_7.png

Source: Starcapital

Let me first discuss value and then give you an example of a lower risk investment with a higher business yield. 

Value investing – Margin of safety

The easiest way to measure value is by looking at the book value. This is just the easiest as value comes in many forms but it will give you a good indication of what are the risks within a business. The price to book value of the S&P 500 is 3.43. This means that when you buy the S&P 500, you pay 3.43 times more than what it cost to build and create the underlying assets of the S&P 500. 

pastedGraphic_8.png

Source: Multpl

You might wonder why would people pay more for something that costs less to build or create? Well, it is based on the good will and belief that those assets will deliver higher earnings and therefore that it doesn’t really matter what the book value is. This might be true given the asset light business models many now have, but as value investors we prefer investments where there is both a good business yield and a margin of safety in the form of value. Why not take both when you can have it both? It just requires a bit more work and research to find such opportunities.

To conclude on book value, history shows the same as what the CAPE tells us. When the book value is high, returns will be low and vice versa.

pastedGraphic_9.png

Source: Starcapital

To conclude on the value and business yield discussion, even Nobel prize winners like Eugene Fama, famous for developing the Efficient Market Hypothesis, agree that value and size are key for achieving higher investment returns. On the size topic, the smaller the company, the better it is because it hasn’t yet been recognized by the market and you might actually get it at a fair price. Thus, you know where to look now.

Current value and strong earnings example plus 5 stocks to watch

According to the above, by investing in something that has a lower PE ratio and a lower price to book ratio, your long-term returns should be higher. Archer Daniels Midland (NYSE: ADM) is such an example. ADM is one of the world’s largest food processing companies, it has a PE ratio of 13.3, implying a business yield of 7.5% and a price to book value of 1.29 that in combination with the food business gives you a margin of safety. The CAPE ratio is similar to the PE ratio.

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Source: Morningstar

On top of everything, the company has been paying a dividend for more than 89 years and dividend payments are constantly increased.

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Source: ADM

If you wish to hear more about ADM, you can check my video analysis.

Here are other 4 companies you might wish to watch and buy when their stock prices offer a good business yield:

  • Apple (NASDAQ: AAPL)
  • Archer Daniels Midland (NYSE: ADM) 
  • Berkshire Hathaway (NYSE: BRK.A, BRK.B)
  • Consolidated Edison (NYSE: ED)
  • The Walt Disney Company (NYSE: DIS)

I firmly believe that having a list of 20 stocks like the above 5, taking a simple look at them once every month and buying those that currently have the lowest long-term average price to earnings ratio is practically all you need when it comes to investing. You will beat the market while taking on less risk, thus reaching your financial independence sooner and safer.

I also firmly believe that a portfolio of companies like ADM will outperform the S&P 500 in the long term due to their underlying business earnings. Over 20 years, the difference is staggering. $1,000 compounded at 4.5% annually leads to an amount of $2,411 while $1,000 compounded at 7.5% annually leads to $4,247. I think these are the things that matter when it comes to financial independence and retirement, safety and yield.

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How can you find such stocks?

It actually isn’t that hard; you just have to be patient and invest when good value businesses trade at lower valuations. Use common sense, look at book values and margins of safety and then simply buy when such a stock offers a business yield that is above your required return. 

The markets are irrational and mostly short term oriented so that even big companies like Apple often trade at low PE ratios offering higher than average yields.