Investors have been gushing over REITS (Real Estate Investment Trusts) for decades saying that these investment vehicles are more stable then stocks and are safer. In 2001 an author stated "need something to round out that tech-laden portfolio? Try real estate investment trusts (REITs). They offer a dividend yield, tax benefits, predictability, and a hedge to inflation and technology investments. Take another look at this misunderstood market" There have also been many books dedicated to the safety of REIT's.
But is this Non Fiction or fiction? Its Fiction
Investors consider these investment vehicles to be very safe because they offer bountiful dividends. This article written nine years ago listed REITs that Warren Buffett had recently bought in 2000 and 2001. Buffett the legendary investor from Omaha Nebraska is known for his stable long term investments. But Consider this, out of the four REITs he invested in only two are around today. (In case you were wondering, he invested in (First Industrial Realty Trust (NYSE: FR), JDN Realty (NYSE: JDN), Tanger Factory Outlet Centers (NYSE: SKT), and Town & Country Trust (NYSE: TCT). If Buffett can't pick a REIT that can last ten years then it should raise a red flag for the individual investor.
The problem with REITs is their structure, the company must pay 90% of their earnings in dividends. Most investors also do not fundamentally understand real estate. They believe all real estate appreciates in value but this only half true. There is a significant amount of upkeep that goes into a building to keep its value. When a property is sold at a higher value it reinforces the idea that all real estate goes up in value. This is an incorrect notion since much of the price can be in the expenses paid to upkeep the building and the appreciation of the land. REIT investors look at Funds From Operations (FFO) which is net income + depreciation. This is an unacceptable valuation model.
If we were to make an example, lets say you bought a house for $300,000 and the land made up $150,000 of the purchase. If the house's value were to start at $150,000 and was never renovated after 40 years the property itself may be worth 4 times as much but the house itself would likely have no value, and it could have negative value. Since the cost of a building for a REIT are often 6-7 times more than the land, then its obvious a building that is not renovated will lose almost all its value.
This has caused REITs to have an unsustainable business model. Most REITs often pay dividends larger than their net income, including General Growth Properties which paid $450 million in dividends in 2007 when it earned $350 million. Simon Property Group largely viewed as one of the strongest REITs has also consistently paid dividends above its net income. Simon Property and GGP have large capital expenditures and have had to borrow more and more money each year to essentially pay their dividends and upkeep their buildings. The amount of debt at Simon Property Group has more than doubled in the last 10 years from $8 to $18 billion. The current REIT structure forces a business to continually borrow until it can earn net income + depreciation that equals interest payments. Once this happens the company can only pay interest payments and the common stock would have no value. The myth that has built up the glorious REITs is that investors believe that buildings do not depreciate in value. REITs may be the most dangerous of any long term investment.
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