The Biggest Misconception About Investing in REITs

No one knows real estate investment trusts better than Ralph Block. He's been investing in this underfollowed asset class for 40 years and is the author of the definitive book on the subject, Investing in REITs, which just came out in its fourth edition. I asked Ralph to join us for a discussion of his latest thinking on the industry and some ideas he's hot on.

Joe Magyer: Thanks for joining us today, Ralph. Let's start with an easy one: What's the elevator pitch on why everyday investors should make room for REITs in their portfolios?

Ralph Block: That one's easy. Over many long periods, REITs have been able to deliver outstanding total returns to their investors, with fairly low correlations to other asset classes, predictable and stable cash flows (due to long-term leases with tenants), and higher-than-average dividend yields. The current issue for REIT investors is whether we will enjoy a reasonably stable economy, which drives the need for tenant space in various real estate sectors. I think we will be OK, notwithstanding very sluggish economic growth.

Magyer: It would be a whopper of an understatement to say that REITs have been on a wild ride since the third edition of Investing in REITs was published in 2006. How have the events of the past five years shaped your thinking about investing in REITs?

Block: My thinking about REITs has changed a bit in a few areas, but more in degree than in substance. First, both commercial real estate prices and REIT stock prices have become more volatile. This requires investors to adopt a longer-term time horizon. Second, we have seen the dangers of financing business operations and property assets with debt, as we don't always know how credit markets will behave. Thus I have become even more sensitive to REITs' balance sheets. I'm more convinced than ever that owning commercial real estate in securitized form, through REIT shares, is the smartest way to participate in this asset class. REITs have proven that they can obtain necessary -- and even opportunistic -- capital when other property owners cannot do so.

Magyer: You've been investing in REITs for decades. What are the most common threads you see in REITs that deliver long-term outperformance?

Block: Two common threads, when present, provide the best REIT share performance. One is the REIT's management team. Owning commercial real estate is capital intensive, and those management teams that understand their cost of capital, how to allocate it wisely, and how to assess property and balance sheet risk tend to outperform on any reasonably long-term basis. Of course, it's not always easy to assess the quality of management, and thus the investor must look at how each REIT has both handled adversity and captured opportunities over time. The second common thread is the quality of the REIT's investment portfolio. I think high-quality properties in the best markets tend to outperform most of the time, especially when property market conditions are difficult. Tenants simply prefer to lease space at these properties, and this helps to generate better returns over time.

Magyer: What is the biggest misconception about investing in REITs?

Block: I think the biggest misconception about REITs -- still -- is that they are mutual funds of properties and that one can do well by simply assessing the prospects for the properties in a REIT's portfolio. This ignores the importance of the management team. Another misconception about REITs is that their purchase and sale can be successfully timed; I don't believe this is so, even for professionals. REIT stocks are correlated to commercial real estate markets, but they are well ahead of them. Successful timing requires getting the entry and exit points right, and that is very, very difficult. A third misconception about REIT investing is that investors want to value them in the way that they value other common stocks. My experience has been that applying, say, a price-to-earnings ratio to REITs' earnings is not very productive -- for the reasons outlined in my book. (I just had to get that plug in there!) REITs are most effectively valued by applying a number of metrics beyond P/E ratios, including estimated net asset values.

Magyer: One of the things I love about REITs is that pockets of market inefficiency seem to spring up because they aren't as widely followed and understood by your average investor. Is that your sense as well, and if so, are you finding it more difficult to ferret out unloved REITs as they've gone closer to mainstream?

Block: Good point, Joe. Until a few years ago, it wasn't that difficult to find many pockets of undervaluation in the REIT world, as the market for these shares wasn't terribly efficient. But REITs are mainstream investments today, and finding those diamonds in the rough is much more difficult. That said, they can be found with some diligence, particularly if you look at the smaller-cap REIT shares. But you must get comfortable with the management teams of these lesser-known REITs. I recommend listening to the quarterly conference calls; they can be very helpful in assessing the management team. For example, is the REIT really creating value in its investment of capital, or is it just out there buying assets at market prices?

Read Part 2 of the interview here!

At the time thisarticle was published Joe Magyeris the advisor ofMotley Fool Inside Value. You can test drive the servicefree for 30 days. The Motley Fool has adisclosure policy.

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