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Economy, Investing  | February 22, 2019

There’s no such thing as a perfect investment.

Let’s start with that reminder before we get into the five REITs you really want to avoid in the next recession. In theory, real estate investment trusts are solid, dividend-producing, recession-resistant entities to put your money in.

In practice, when run by well-connected, well-experienced management, REITs let you into the moneymaking world of real estate without taking on too much of the associated risk.

But in both theory and in practice, there is still at least some associated risk.

Last week, we explored a short list of the best-positioned REITs to consider in case of a recession. Today, though, let’s look at the opposite side of the real estate coin: companies that won’t be so properly placed when the chips are down.

After all, successful investing isn’t just about knowing what’s worthwhile. It’s also about knowing what to avoid.

Most Lodging REITs Are NOT Recession-Resistant

There are certain REIT sectors that can weather most economic storms that come their way. But then, there are those you should automatically expect to take a hit.

It’s just the name of the game. Or, more precisely, it’s basic economics.

When wealth is growing, consumers tend to spend money on what we call luxury items: purchases they can, in fact, live without. When income is less stable, people cut back.

They stop refurnishing and redecorating their houses, buying expensive jewelry and eating out.

And they either put their vacation plans on hold, or they tailor them down to size.

That’s why lodging REITs are rarely a good place to keep your money, year in and year out. They’re too temperamental.

To be clear, I’m not expecting anything as intense as what we saw with the last recession. That was one for the books.

However, even less-significant downturns have proven to be unfavorable for the sector.

Think about it… If you don’t have a guaranteed bonus coming in at the end of the work year, are you really going to use the finances you do have on non-necessities like hotel rooms, the added gas to get there, and all those purchases you know your significant other (and/or kids) are going to want to make along the way?

Maybe not.

You’ll be even less likely to splurge on high-rolling hotel rooms at the Marriott or Hilton hotels. Hampton Inns or its equivalent will do just fine, thank you very much.

Residential Mortgage REITs Won’t Be Looking So Good

Residential mortgage REITs are another sector set to fall whenever the next recession hits. To know why, you have to first understand what a general mortgage REIT is.

Here’s the basic rundown, as quoted from my book, The Intelligent REIT Investor:

Similar to banks and other financial institutions, mREITs lend money to real estate owners directly by issuing mortgages, or indirectly by acquiring existing loans or mortgage-backed securities. In contrast with equity REITs that derive the majority of their revenue from leases, mREIT revenue equals the principal and interest payments received from real estate-based loans.

Since they borrow money at one particular percentage amount and lend it out at another, profitability is very tied to interest rates. Usually, mREITs do better when interest rates are steadily rising higher, which just does not happen during a recession.

Furthermore, the residential mortgage REITs use high leverage; as in any form of investment, the more debt you use, the greater the potential for gain or loss. When you buy stocks on margin, you are leveraging investment returns with debt. And any asset carried on high margin involves substantial risk, since a decline in the asset's value will cause a much larger decline in the original investment (principal).

Essentially, it is the beneficial use of borrowing money that magnifies returns (leverage), and the reason spreads for mortgage REITs are wider and dividends are much higher (than equity REITs). To put it bluntly, as I’ve often argued, mortgage REITs do not belong in a retirement portfolio.

Shop Happy. Shop Smart.

A third sector to be cautious about is shopping center REITs, though this warning is dependent on one significant factor.

If the REIT you’re looking at has a tendency to invest in necessity-based, i.e., grocery store-anchored shopping centers, then it’s in a much better space. Literally.

Consumers can do without buying clothes from boutiques in a recession. They can cut back (pun intended) getting their hair styled just so, or their nails done up, or buying the latest and greatest pricey gadget to hit the stores.

But they can’t do without food. That’s kind of a necessity.

With that in mind, look for shopping center REITs whose main attractions are grocery stores like Giant, Stop & Shop, Target, Publix, HEB, Walmart Supercenters, and the like. For that matter, Sam’s Club, BJ’s, and Costco all make for steadier profits, as well.

The above chart provides an overview of the best and worst property sectors (based on price performance) from 2007 to 2009. The lodging sector was hit hardest in 2008, but also bounced back the strongest in 2009.

Industrial and Office sectors also got hammered in 2008; however, I believe the next recession will be much less severe. Also, e-commerce has been a huge catalyst for industrial REITs, and that should result in prolonged growth.

As such, the key to picking the best “Recession-Ready” REIT is rooted in “necessity” - and when you decide where to allocate capital, ask yourself if the REIT is providing something crucial to the end customer… needless to say, all of us need food, shelter, and clothing.

The 5 REITs You Can Set to the Side

Now that you have the basic overview, let’s get down to specifics. Which 5 REITs do you definitely want to avoid when the next recession hits?

Whitestone REIT (WSR) is a shopping center REIT that owns 68 Community Centers with approximately 6.1 million square feet of gross leasable area, located in six of the top markets: Austin, Chicago, Dallas-Fort Worth, Houston, Phoenix. Although the company has enhanced geographic risk (primarily in Texas and Arizona), it has a diversified portfolio of over 1,600 tenants.

And although Whitestone indicates (in their investor deck) that the portfolio is e-commerce resistant, I remain skeptical of that claim during the next recession. A large majority of their tenants are mom & pop owners, which means that they’re exposed to higher interest rate risk, during a recession. In addition, Whitestone is highly leveraged (8.5x leverage), and funding practices have been less disciplined than most of its peers.

Finally, Whitestone’s dividend growth is non-existent. Since going public in 2011, the company has maintained a flat dividend of $1.14 per share. Also, FFO per share has declined, making this REIT somewhat of a sucker yield (97% payout ratio) and value trap. Given the future growth prospects, we recommend avoiding Whitestone, and we maintain our Sell rating.

Washington Prime (WPG) is a mall REIT that was formed as spin-off via Simon Property Group’s (SPG) lower-quality retail assets. The company owns 109 assets comprised of 60 million square feet and about 100 at-risk anchor properties (39 Sears, 36 JCPenney, 8 Belk, etc.).

WPG’s dividend has been frozen since 2015 and has seen AFFO/share steadily falling since 2014. The AFFO payout ratio is now closing in on 100%, and analysts expect the REIT’s cash flow to shrink further in 2019, pushing the payout ratio to an unsustainable 111%.

That falling cash flow means that the dangerous 7.1 net leverage ratio is expected to rise to 7.2, and combined with WPG’s need to invest heavily into redeveloping stores to try to replace bankrupt anchor tenants, its dividend is almost certainly doomed to be cut in 2019. And like CBL (CBL), Washington Prime’s weak balance sheet (so bad it doesn’t even pay S&P to rate its debt) means that, during a recession, the dividend might have to be suspended entirely (go to zero).

But I’m not waiting for the next recession for this sucker yield’s destiny as a future dividend cut (it’s on our “stinky alpha” list). We maintain a Strong Sell.

Braemar Hotels (BHR) began trading in late 2013 (as Ashford Hospitality Prime, Inc.) and now owns 12 hotels with 3,576 net rooms. As we mentioned, we expect lodging REITs to perform poorly during a recession, and especially in the kinds of luxury hotels Braemar owns.

In addition, Braemar has high leverage, with 45% net debt to growth assets; the trailing 12-month fixed charge coverage ratio was approximately 2.1x. Another concern is the company hasn’t grown its dividend (pays $.64 per share) and is unlikely to do so, over the next two years.

Shares have returned 34% year to date, and we have subsequently reduced exposure and now rate the company as a HOLD (was a Spec Buy). As the economy moves closer to the recession cycle, we would recommend avoiding lodging REITs that cater to bigger ticket consumers.

Ryman Hospitality (RHP) is another lodging REIT that yields caution. Smaller than its peers, in the number of assets, Ryman owns and operates a network of four upscale, meetings-focused resorts, totaling 8,609 rooms, many under the Gaylord Hotels brand.

These four resorts are the Gaylord Opryland Resort & Convention Center in Nashville, Tennessee (Gaylord Opryland), Gaylord Palms Resort & Convention Center near Orlando, Florida (Gaylord Palms), Gaylord Texan Resort & Convention Center near Dallas, Texas (Gaylord Texan), and the Gaylord National Resort & Convention Center near Washington, D.C. (Gaylord National).

Each of Gaylord Hotels' properties has at least 400,000 square feet of meeting, convention and exhibition space, food and beverage options, and retail and spa facilities, within a single self-contained property. This business model works well in the good times, but when a recession hits, convention traffic declines.

We have done well with Ryman. In late 2017, we recognized a disconnect and took a modest position, ultimately exiting in August 2018 with 35% returns. More recently, we have been fearful of the lodging cycle and recognizing that this sub-sector gets hit harder during a recession, we remain in a HOLDing pattern.

Outfront Media (OUT) is one of the largest out-of-home media companies in North America with a portfolio of around 500,000 digital and static displays, which are primarily located in the most iconic and high-traffic locations throughout the 25 largest markets in the U.S. The company went public (IPO) on March 28, 2014, and began operating as a REIT on July 17, 2014.

In addition to high capex costs, the billboard business model does not provide the income sustainability warranted by other property sectors (due to the fluctuating ad-based business). This means some of the underlying assets owned by Outfront could be subject to uncontrollable risks (economic, governmental, and competitive), as well as declining revenues.

Keep in mind, we upgraded OUT from a buy to a strong buy in October, and since that time, shares have returned 23%. Now, we are downgrading the company to a regular Buy (remember, our Strong Buy target is 25% returns in 12-18 months). However, we are becoming a bit less bullish as we recognize that a recession is on the horizon.


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