REITs Are Terrible Investments: Closed-Funds

This crisis is exposing the cold-hard truth that REITs are terrible investments. These closed-end funds are the epitome of toxic assets.

I thought after 2008, investors would have learned their lesson and abandoned the asset class permanently.

Unfortunately, it is hard to be contrarian when everyone else is making money hand-over-fist, while you feel like a full for skipping the party!

REIT

REIT stands for “real estate investment trust”. Essentially, it is a pool of money from to buy large-scale real estate holdings for investors.

Imagine buying a piece of commercial property for $300 million. There are only a handful of Americans who have enough idle cash reserves to purchase the property individually.

So, the solution is to pool resources, spread among hundreds or thousands of people, and buy the property together.

It helps protect investors with diversification. Thus, if the property is a terrible investment, you would only lose a little money, rather than everything.

The majority of REITs are created to finance large apartment complexes, shopping malls, business developments, and other capital-intensive projects.

But, REITs are terrible investments!

2008 All Over

REITs were the hottest investments before the Great Recession. Every financial advisor wanted their clients to own them because their returns shot up like a rocket!

Salesmen (oh my bad, financial advisors) recommended these funds because they had high commissions. They weren’t really great products.

In fact, I have read through some old fund prospectuses, and you would have to be completely ignorant of finance and accounting to believe these things were sound.

I mean come on though, real estate prices never fall. As long as properties continued to appreciate, the investments would generate ample returns for shareholders.

However no one took the time to actually fundamentally analyze the properties. Real estate is the easiest asset in the world to value.

It is all a function of rent, interest rates, property taxes, and insurance. You can amortize maintenance and repairs and know your return for the next 30 years.

Really, it is that easy. This is how I knew 5 months ago that real estate prices were expensive. I wrote an articled called “Home Prices Are Overvalued“!

Remember, it’s all a function of rent. If everyone can’t afford to pay rent, your real estate will be worth significantly less.

I know people who were conned into these funds and ended up losing 90% of their money. But, these are the same people who bought REITs again!

Not Safe AT ALL!

Most people buy these funds because they have stable dividends. This is why they are so popular with retirees and pension funds.

People never stopped to think about the risk they were incurring to generate those returns! REITs are terrible investments when comparing risk to reward.

Fund managers mistake leverage for genius. Just because an investment generates a 15% return doesn’t mean it was smart.

You always have to look at the coefficient of variation, which is a measure of risk to reward.

It is calculated by dividing the standard deviation over expected return. And wouldn’t you know, REITs have horrendous volatility.

REITs commonly have 80% leverage to meet dividend and return expectations. You would never borrow 80% to buy a stock.

However, because most banks view real estate as a safe form of collateral, these risky loans can be originated.

Interest-Only

I would venture to say 99.99% of all REITs operate on interest-only loans. Meaning, they never pay down the principal balance.

This decreases the monthly payments, and it frees up cash-flow to be distributed to investors.

Essentially, they’re all adjustable rate mortgages. This didn’t bring down REITs in 2020, but it did crush them in 2007.

Interest-only loans contain a massive amount of uncertainty, unless you hedge the interest-rate risk with swaps.

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Leverage Amplifies Returns

Let this be clear. Leverage never increases investment returns, it can only amplify them. What does this mean?

Assume we have two investors (A & B). Investor A is extremely risk-averse, and he refuses to use debt. Contrarily, investor B loves debt, and he will use it for any opportunity.

Both investors buy a piece of real estate for $200,000. A pays for the property with cash, but B puts $40,000 down and borrows $160,000.

At the end of the next year (assuming nothing went tragically wrong), both investors collect $12,000 in rent.

Let’s also assume B has to make $9,000 in mortgage payments, so his after-expense return is $3,000.

A will have a return of 6% (12,000/200,000), but B will have a return of 7.5%(3,000/40,000). Nothing about the deal changed other than the financing.

B was able to increase returns by 25% over investor A simply by using leverage. Leverage amplifies returns, it does not increase them!

On the flip side, if the property were to lose money, investor B would lose significantly more than investor A.

Just like alcohol, leverage makes good investments better and bad investments your worst nightmare!

This is another reason REITs are terrible investments. The leverage is far above what most rational investors would assume.

Closed-End Funds

Closed-end funds differ from open-ended funds in fundamental ways. A closed-end fund raises a prescribed amount of capital only once, by issuing a fixed number of shares.

After all the shares sell the offering is “closed”, hence, the name. No new investment capital flows into the fund.

In contrast, mutual funds and exchange-traded funds constantly accept new investor dollars, issuing additional shares, and redeeming shares from shareholders who wish to sell.”

Closed funds are incredibly risky. You are locking-in your money for 10+ years. There are companies that prey on individuals that need liquidity.

My parents once owned a closed-end fund, and they were offered 50% of fair value. For those people who are forced to sell, you will take a big haircut.

NRZ

NRZ is the ticker symbol for New Residential Investment Corp. This was one of Wall Street’s most popular REITs. Well, until a couple weeks ago!

I think the following image might offer some insight into the reason why. NRZ’s price fell from almost $17 in January 2020 to $3.60 in March!

As you can see, over the last 5 years the price of NRZ has been relatively steady. What happened that made the price crash so dramatically?

nrz proves why reits are terrible investments
Source: Yahoo Finance

NRZ was wildly popular for retirees because it paid very high dividend yields, ranging from 5-6%. This is far more than interest rates on CDs and government bonds.

Investors were yield-starved in a global environment of low rates. Will Cohen describes the phenomenon as the “yield hunger games”.

Investors will accept dramatic levels of risk for a little more return. Well, when tenants stopped paying their rents, NRZ cut its dividend by 90%!

I feel terrible for the retirees who might have solely relied on this fund for income. It’s an important reminder that nothing in life is risk-free. Not even government bonds!

Cardone Capital

For those of you who don’t know, Cardone Capital was funded by Grant Cardone. Grant is a business speaker, best-selling author, and real estate investor.

I like Grant’s spirit of winning and 10x your life. However, I think his business advice is absolute garbage.

He adamantly urges people to go deep into debt to buy rental properties and eek out maximum returns. Grant adamantly boasts to his social media followers that he’s billions of dollars in debt.

I mean, that’s not something I would brag about, but it appears the chickens have come home to roost. The days of his social media bragging have collapsed.

Cardone Capital has laid off over 50% of its employees. Cardone is not alone in feeling the brunt of economic damage.

He’s crumbling under the mountain of debt and promised dividends for investors. Grant “guaranteed” 15% returns for most of his funds.

Yeah, safe to say, I don’t think that’s happening. He just might have to kiss his jet goodbye. Don’t get lulled to sleep by flashy salesmen.

Small or Big Ship

I once heard this analogy, and I absolutely love it. There are only two ways to navigate real estate. You can be a big ship or a small ship.

Imagine a big ship being a large cargo vessel, and the small ship is a speedboat.

When everything is going well, waves are smooth, being on a large ship will be much faster for traveling long distances.

However, when trouble starts to stir, being on a small ship is mush easier for turning around or adjusting course.

Have you ever seen a big ship try to stop or turn? It takes minutes, but a speedboat can stop on a dime like nobody’s business.

I would recommend being a small ship when it comes to real estate, owning a few rental properties with ample reserves.

I hope to own my first rental property in the next 12-18 months, and this is the philosophy that will guide my investing process.

I will keep 6+ months of rental payments in liquid cash to be able to meet any obstacles thrown my way. This could be vacancy, maintenance, or big repairs (roof, HVAC, natural disaster).

I plan to screen my futures tenants diligently, and I will go as far as the law allows. Proof of income, credit score, background check, and legitimate references.

“There are only three ways that a smart man can go broke: liquor, ladies and leverage”

I plan to lower my rental rate slightly below market, so I can be more selective with tenants. I’d rather have a little of something, than all of nothing!

VGLSX

Now, after all this, if you’re determined to own a REIT, I would recommend VGSLX. It is a Vanguard REIT index fund.

reits are terrible investments buy vgxlx is my favorite

The advantage is the fund isn’t closed, and you can get in and out whenever you like. Thus, no 50% fire sale prices if you decide to sell.

It can be a good way to diversify your portfolio. However, it’s not really a negatively correlated asset, so its impact is limited.

The expense ratio is far lower than other actively managed funds, and I am a massive proponent of low-cost investing.

REITs Are Terrible Investments

This crisis is exposing the cold-hard truth that REITs are terrible investments. These closed-end funds are the epitome of toxic assets.

I thought after 2008, investors would have learned their lesson and abandoned the asset class permanently.

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