I was a landlord once and it didn’t turn out how I expected. I think it mattered that I didn’t set out to be a landlord. I had bought a house in Baltimore City that I expected to live in for many years. Then my job relocated me to sunny Florida (who would pass that up?).
I used a family friend who was a property manager, and things were fine for a few years. I had a long-term tenant, but COVID completely turned her life upside down. When I got the property back it was completely trashed—broken windows, rats, appliances dismantled.
I was lucky though. Since I purchased in 2012 and was selling in 2021, there were investors who were more than happy to take the property off my hands. I walked away with a 5% profit.
In the end, I was grateful to escape escrow with any number greater than zero. Still, everybody knows that 5% is a terrible return for a 9-year investment. The current Yield Shark portfolio has 12 stocks marked “Buy” right now that pay over 5% in income every year.
One of those is a REIT that would have paid me a much better return than my rental property.
Different Types of REITs
I talk about REITs all the time because they are passthrough entities you can use to easily invest in real estate. They were created under a portion of the Cigar Excise Tax Extension of 1960. The intent was to give individual investors access to real estate. And they still do that to this day.
REITs are traded easily on major US exchanges and don’t require special tax forms like other passthrough investments.
All the REITs that I’ve recommended and talk about in this letter are considered equity REITs. They invest in hard real estate assets. But recently I was asked what I thought of mortgage REITs (mREITs), especially with today’s higher mortgage rates. As the name suggests, mREITs invest in mortgage-related products.
A small slice of mREITs actually issue their own loans, but it’s not common. mREITs can also hold mortgage servicing rights. This is when a loan originator or bank pays a third party to handle the administrative functions of the mortgage. The REIT is then responsible for collecting the payments and other administrative tasks in exchange for a fee. The majority of mREIT investments are in mortgage-backed securities or a bundle of home loans.
Mortgage-backed securities can themselves be comprised of agency-backed or non-agency-backed loans. Agency-backed loans are those guaranteed by a government agency such as Fannie Mac or Freddie Mac. If agency-backed mortgages default, they will be bought back by the agency. Since 2008, mREITs lean heavily toward owning agency-backed bundles.
mREITs make money by using leverage. They borrow money to buy the securities. The investment income is the difference between the interest earned on the mortgage-backed securities and the interest paid on the borrowed money.
Although current mortgage rates are higher, REITs also pay more to borrow money. Plus, mortgages backed by government agencies have lower yields—it’s the price you pay for added safety.
All these factors are why I don’t generally recommend mREITs. It’s all about timing, and that’s not really what we’re about. And data from the National Association of REITs (NAREIT) supports this. According to NAREIT, the average total return for mREITs over the past 20 years including dividends is just 1.9%.
Where Is the Growth Potential for REITs?
This is the important question I’m asking myself as I manage our REIT exposure. As income investors, finding a solid income stream is our first goal. And we want those streams to be either: 1) consistently increasing, or 2) above average. It’s always a nice bonus when we can get both. Most of the time, REITs fall into that second category. Passing through 90% of their income to shareholders gives REITs a leg up to beat the yields of other dividend stocks.
One of my favorite REITs over the past few years has been Innovative Industrial Properties (IIPR).
Industrial REITs focus on properties used for logistics such as manufacturing, warehouses, or fulfillment centers. These types of properties are often rented on long-term leases which could be as long as 25 years. And companies will typically rent an entire industrial building under a triple net lease structure. Under triple net, the tenant is responsible for covering building insurance, real estate taxes, and maintenance.
IIPR specializes in real estate used for the growing and associated logistics of the legalized cannabis industry. The REIT was founded in 2016 and was the first publicly traded REIT in the regulated cannabis industry. There are now a handful of other REITs in this sector.
I first recommended this position to my Yield Shark readers in August 2022, and we locked in a 7.5% yield. However, just last month, I moved this position to a “Hold.” This means I don’t think it’s a good time to initiate or add to our position. The reason for the switch is all about growth potential.
IIPR’s tenants have a good track record of paying their rent on time. Even when a tenant falls behind on rent, the company moves quickly to legal solutions. Once the property is vacated, it doesn’t stay vacant for long.
These are specialized properties that must follow a laundry list of government regulations. There’s ample evidence that their business is solid, but I’d like to see more properties being added and leased out.
Even though IIPR isn’t my favorite REIT right now, industrial REITs are a section of the REIT universe that should be on your radar. Most industrial tenants require heavy and/or specialized equipment for manufacturing. Just imagine how much fun it would be to move an entire fulfillment center just because your lease is up. Switching costs are high. That’s why renewal rates are also high.
Do you guys agree with me? How do you feel about real estate right now? Do you have physical real estate investments, or do you think REITs are an easier, more lucrative way to play? Send me your thoughts here.
For more income, now and in the future,
Kelly Green
A message from Advisor Perspectives and VettaFi: To learn more about this and other topics, check out some of our webcasts.
© Mauldin Economics
Read more commentaries by Mauldin Economics
