Very few industries have been left unscathed by the COVID-19 pandemic, and REITs are no exception. As you would imagine, the deep recession we find ourselves in has put a damper on demand within most real estate sectors, and prices have declined significantly in the first half of 2020. As of June 30, the FTSE Nareit All REITs Index showed a year-to-date total return of -15.01%. This has boosted the average dividend yield to 4.33% from its 2019 reading of 4.06%. Does this portend greater losses ahead, or is this a historic buying opportunity? Read on for some context on where we go from here.
Rent Collections Under Pressure
When people can’t work and businesses are shuttered, paying the rent becomes highly problematic. As REITs depend on rental income, it’s not hard to see why the industry is suffering. Tens of millions of workers have been laid off their jobs, creating unemployment numbers not seen since the 1930s. Under these conditions, rent collections drop, property prices fall, lease demand declines, and new construction slackens.
For some REITs, the biggest challenge is to remain solvent. It’s hard to see much improvement in the real estate industry until a COVID-19 vaccine is widely available. Yet investors who wait until then will likely find themselves late to the recovery, which is why many advisors say to hold or improve your REIT positions as you ride out the storm.
Sector Performance Varies
Figure 1 below shows REIT performance for the first half of 2020[1]. Almost all sectors are underwater for the period, with lodging and retail the worst hit. However, the infrastructure, data center, and industrial sectors posted gains. Diversified REITs showed a decline of -30.61%.
For dividend players, retail and lodging provided the highest yields. But as we shall see, dividend risk is a real problem.
For retail-sector REITs, the challenge is to maintain their occupancy levels even as retailers are forced to close or to limit traffic. In April 2020, retail rent collections fell by one-third[1]. Collections have doubtlessly deteriorated since then. REITs with the largest cash cushions may be able to suspend rent collections, ask for lease extensions, or substitute some rent with a percent of sales until conditions improve. These measures may help REITs secure future cash flows and longer occupancies.
Pressure on Dividends
Vehicles like REITs, mutual funds, and exchange-traded funds must pay out 90% of their taxable income in dividends to investors. Failure to do so will result in the loss of pass-through status, meaning these funds will face taxation. In addition, funds must keep enough cash to remain liquid during challenging economic conditions.
Thus, REITs must balance the requirement to distribute dividends with the need to conserve cash. Typically, when REITs come under intense revenue pressure, they look to cut costs and even liquidate some properties. Naturally, lower income translates to lower dividends that drive share prices down. A REIT with no taxable income will likely pay no dividends at all.
As REITs are primarily favored by fixed-income investors, dividend cuts disrupt investor income expectations. Weak-handed investors may sell their shares at a loss. Weaker REITs may sell some of their properties at a loss. Therefore, capital gains are less likely during the Covid-19 pandemic.
Liquidity
To the extent that equity REITs finance their properties with debt, reduced income can result in defaults. Foreclosure, reorganization, or bankruptcy may be the ultimate outcome.
Mortgage REITs depend on the monthly payments from borrowers. When mortgage holders can no longer make their payments, REITs may be forced to foreclose on properties, saddling the fund with non-productive assets of diminished value. Alternatively, mortgage REITs may attempt to sell off non-performing mortgages, typically at a deep discount to book value. Either alternative locks in losses.
REITs as Lenders
By law, REITs must invest at least 75% of their value in real estate assets, cash, cash receivables, and government-issued or -guaranteed debt securities. Earned interest (from short-term CDs, demand deposits, and money market instruments) are “good” assets for the purposes of the 75% test. Repos, banker acceptances, and debt holdings are “bad” assets, excluded from the test. Now, what happens when the value of real estate assets declines such that the REIT no longer satisfies the 75% test? In that circumstance, the REIT may not have enough money allocated to assets that satisfy the 75% rule. Without immediate reallocations, the REIT could lose its tax-advantaged status.
Remedies for REITs During the COVID Pandemic
REITs may look to reduce taxes and conserve cash during the current situation.
Due to low share prices, REITs that need additional capital will justifiably want to avoid secondary equity offerings. Instead, many REITs will turn to debt offerings to raise capital. This has the added benefit of increasing tax-deductions, a result of higher interest costs.
Dividends are also deductible (in the sense they are passed through to investors tax-free at the REIT level). REITs that pay 100% of their income to investors have no taxable income. Moreover, REITs can deduct in the current year the dividends to be paid in later years. This further reduces current taxes.
Another remedy for cash-strapped REITs is to postpone quarterly dividends until one month beyond the end of year. This will not jeopardize the REITs tax status as long as it satisfies the timing requirements.
Investor Considerations
Value investors may look upon pandemic-deflated prices as a long-term opportunity to acquire basically sound assets at a sharp discount. But investors should avoid value traps in which REITs cannot sustain high dividend distributions.
Investors who are sensitive to the amount and timing of dividends should also exercise caution when adding REITs to their portfolios. The payouts may fall during the pandemic, and quarterly dividends may be replaced by annual ones. If you live off your investment income, or you use that income to finance other investments, these shortfalls in current payments may prove to be inconvenient or worse.
Thus, REIT investors must perform heightened due diligence when sussing out REITs that can handle the current economic challenges. Note that the 10 largest retail REITs were sitting on large cash stockpiles before the pandemic hit. But we really don’t know how much damage the coronavirus will inflict on REITs before this episode ends. Therefore, you will want to keep up with the latest financial news and information.
[1] https://www.calvert.com/impact.php?post=the-covid-19-opportunity-for-retail-reits-invest-in-tenants&sku=35811
[1] https://www.reit.com/sites/default/files/returns/prop.pdf
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