Real estate investment trusts (REITs) can be a great way to build wealth via real estate. These vehicles enable investors to own an interest in a portfolio of income-generating commercial real estate that throws off dividend income and delivers a capital gain as they grow their market capitalization.
However, not all REITs are worthwhile investments, and some should be avoided outright.
The characteristics of the worst REITs
Before we dive into which REITs to avoid, we should identify the characteristics found in poor performers. The three most common traits of money-losing real estate investment trusts are:
- Excessive leverage. While debt is important for helping finance real estate acquisitions and developments, too much can weigh a REIT down. One way to determine whether a REIT has too much debt is to compare its leverage ratio to others in the sector. As a rule of thumb, a debt-to-EBITDA ratio of more than six times or a debt-to-capitalization ratio well above 50% are red flags.
- An unsustainable dividend payout ratio. REITs must pay out 90% of their taxable income to maintain their REIT status. However, their funds from operation (FFO) is usually much higher than ordinary income, which is why it's the more important number to consider when it comes to REIT dividends. If the FFO payout ratio, however, crosses above 100%, it's a huge red flag since the REIT can't deliver any dividend growth.
- Focusing on real estate that lacks upside. For a REIT to grow shareholder value, it needs to hold commercial real estate that can increase its rental income. That's nearly impossible to do if it concentrates on markets with too much supply (e.g., high vacancy rates) or focuses on owning properties leased to tenants in struggling industries (e.g., retail).
Three REITs to avoid
There are great REITs, average ones, and ones most investors probably won't want to own, no matter how high the yield or what story management spins. Right now, Whitestone REIT (NYSE: WSR), Preferred Apartment Communities (NYSE: APTS), and The GEO Group (NYSE: GEO) all fall into that last category. Here's why you're better off avoiding this trio of REITs at all costs.
1. Too small, too focused
The first name up is Whitestone REIT, which owns community shopping centers. That's a fairly reliable property type most of the time, filled with tenants like grocery stores, nail salons, and restaurants -- places people visit every day. The coronavirus made 2020 a tough year, but that was true throughout the sector and not really a reflection on Whitestone REIT.
The bigger problem is that this REIT is kind of tiny, with just a $400 million market cap. It only owns around 60 properties in total, and roughly 70% of its portfolio is in just two markets: Phoenix and Houston. Stepping that back to the state level, 99% of its properties are in Texas and Arizona. In other words, this is a small REIT with very little diversification.
You can argue it's an expert in the areas it serves, which is management's take on the matter, but for most investors, a larger, more diversified option will be a better call in the shopping center space. And, it's worth noting that Whitestone cut its dividend by 63% in 2020. When you look at the total package here, it's just not worth owning at this point in time.
2. If it were so great, everyone would do it
The next REIT here is Preferred Apartment Communities, which is a terrible name. Indeed, investors might read it to mean that the company buys desirable apartments. However, that's not really what's going on.
For starters, Preferred Apartment Communities' portfolio is spread across the apartment, strip mall, and office sectors, which makes the inclusion of "apartment" in the name a bit misleading. Second, the word "preferred" is a reference to the company's use of preferred stock as a funding source. And that's the big problem here.
The company basically sells, on a continual basis, preferred stock that it uses to buy real estate. On the surface, that's just a funding decision, but there are implications. For example, preferred stock ranks higher up in the capital structure than common stock. Preferred dividends have to be paid first, and in a liquidation event, preferreds have a higher likelihood of receiving cash. And the preferred holders can make the REIT to buy them back, which may force Preferred Apartment Communities to issue stock at inopportune moments. That's exactly what happened in early 2020.
Plenty of REITs use preferred stock, but Preferred Apartment Communities' extensive use of it is unusual. On the surface, it sounds like a good idea, but if going to such an extreme were so beneficial, more REITs would do it. Note that the REIT cut its common dividend by 35% in 2020, while the preferred dividends held up just fine. Conservative types should worry about that.
3. A major headwind
The last name here is dealing with a concentration issue of a different sort. You see, The GEO Group is one of the largest publicly traded owners and operators of prisons. That means that the U.S. government, at various levels, is its primary customer. On one hand, that's good, because Uncle Sam is a reliable payer. On the other, it exposes GEO Group to some unique risks, like shifting political views.
That's a potentially big problem today, because the current administration in Washington, D.C. has taken a dim view of using for-profit contractors in the prison sector. The GEO Group has already highlighted two federal contracts it expects won't be renewed so far in 2021. At this point, the issue is largely contained to two customers, the Federal Bureau of Prisons and the U.S. Marshals Service, but it's possible that what starts at the federal level will eventually filter into other areas.
The GEO Group has now suspended its dividend after cutting it in each of the previous two quarters. Although there are various reasons for this move, it's a statement to how big a headwind the company is facing today. And with the likelihood of another three-plus years of pressure at the federal level, most investors will probably want to avoid this REIT until there's more clarity about the future -- GEO Group may not even stay a REIT. And, at the end of the day, owning a REIT that doesn’t pay a dividend kind of defeats the purpose of owning a REIT, which is specifically structured to pass income on to shareholders.
Why take the risk?
Whitestone REIT, Preferred Apartment Communities, and The GEO Group aren't the only REITs that investors can buy. In fact, there are plenty of truly great REITs out there with generous yields if you take the time to look. So why bother adding risky REITs to your portfolio? It's just not worth it.