When Is Good Bad, And Bad Really Good?
My young son Drew and I spotted a cool convertible pulling in the parking lot. He said, “Dad that car is really baaad!”. I said I thought it was pretty neat. He then explained how I was no longer hip, now “baaad” means good. For the last 50 years, when someone says something is bad, I have to stop and think, do they mean bad, or good.
In our recent article, “Are Real Estate Invest Trusts Safe Investments?” we interviewed expert Tim Plaehn of The Dividend Hunter on the subject. When I buy CD’s I start with the highest yields and work from there. Those metrics don’t always work well when applied to dividend paying stocks, particularly Real Estate Investment Trusts (REITs).
The Investor’s Dilemma
(NOTE: With the current Fed interest rate cuts, the above numbers are fluctuating wildly) With safe, fixed income investments that don’t pay enough to beat inflation, how does an investor pay the bills, stay ahead of inflation, and not worry every night? I don’t think we have seen the bottom when it comes to interest rates. Like it or not, investors must understand risk and how to manage it.
Tim Plaehn recently sent an email, “Sell these 3 high-yield stocks before they blow up your portfolio.” It contained an article, “How to Spot the Good REITs from the Bad REITs and The Really Bad REITs”. Two comments grabbed my attention:
“Ignore the 10% yield and sell.
In the case of mall REITs, the high-yield is a true danger signal to sell and stay away.”
What looks good is bad? If 10% is bad, is 5% good? I’m sure many brokers are touting the risky high yield to their clients as good. Many investors, desperate for income, took their advice and grabbed individual bonds or funds. How does the average investor tell the difference?
With the market in a decline and interest rates continuing to fall, I contacted Tim, hoping he would continue with his educational lessons.
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DENNIS: Tim, on behalf of our readers, thanks for your time. Let’s get right to it. You mentioned high rates might be a danger signal, yet some REITs paying, say 7% might be terrific, whereas others yielding 7% can be a danger signal. Using the dividend yield alone as the primary measure doesn’t seem to cut it. Can you explain.
TIM: Dennis, thanks for inviting me. We live in a time when the market is not efficient in putting values on many stocks. This is especially true with income stocks. From my observations, the market is no longer efficient when putting value on a company’s business or ability to pay dividends.
I attribute the inability of the stock market to do its “job” in valuing stocks to the rise in ETF investing. ETF managers buy and sell shares of individual stocks to match the market weight of stocks as designated by an index. There is zero fundamental evaluation by index tracking ETFs.
DENNIS: In your write-ups you mention “leverage” quite a bit. Can you elaborate on this? Is that like an average investor buying stock on margin? Isn’t that high risk?
TIM: Leverage – borrowing money to buy investments – is a powerful tool to boost returns. If the investment earns more than the cost to borrow, the leverage boosts your return on capital.
An individual brokerage account allows an investor to employ up to one times leverage. For example, with $100,000 in an account, the investor could buy up to $200,000 worth of securities. The leverage effectively doubles any gains or losses in the portfolio. The danger is with losses, the broker will issue a margin call, locking in the losses for the investor.
With certain types of REITs, leverage can reach six to eight times equity. These REITs use leverage to boost the yields from low yield securities, such as agency mortgage-backed securities (MBS). Yes, it is similar to buying on margin, only it has more leverage.
DENNIS: Two of the three examples in your email were REITs specializing in financing. Isn’t that the same as speculating on the direction of interest rates? It looks like they don’t actually own any real estate, they own debt instruments. Their underlying investments are likely paying low rates and for them to offer double digit yields involves some risk. Wouldn’t double digit yields over time almost require them to get every bet right?
TIM: These companies have a lot of financial tools and options, so they don’t have to be 100% right. The biggest danger is a flat yield curve, so the metric to watch is the net interest rate spread the leveraged REIT portfolio generates.
A shrinking rate spread will force the REIT to cut dividends. If the rate spread goes negative, the company would be forced to sell its mortgage securities at a loss, putting the whole business model in danger of collapse. The good ones stay ahead of the game up to a point. These companies report their net spread every quarter, so you can determine the dividend safety.
DENNIS: In the article you say, “…. You need to understand how each company generates cash flow to pay dividends. Avoid those where the cash flow per share is at risk due to unreliable or suspect business operations or a fundamental flaw in the business model.”
I’m probably old fashioned, but I understand shopping malls, office buildings, brick and mortar kind of things. Conversely, I suspect the banks keep the prime mortgages on their books to keep regulators happy, and unload those with higher risk to someone else. What do you look for as a “good” versus “bad” potential pick?
TIM: You are exactly right! I discussed above the risks to the agency residential MBS owning REITs. In contrast, commercial mortgage REITs are completely different. Some commercial REITs make low LTV (Loan to Value) loans on high quality properties and keep the best of those loans in their own portfolios. Other REITs have different business models as far as the investments they make, the risks they retain vs. selling off, and the level of leverage used in the portfolio.
I have so far just discussed finance REITs. Equity/property owning REITs are a completely different category, where the sub-categories determine much of the investment risk and potential. REIT categories include healthcare, shopping centers, apartments, self-storage, industrial, office, and there are even cell-tower, billboard and prison REITs.
Each category has its own rewards, challenges and business cycle. Each company in each category has its own management plan to produce attractive shareholder returns. I have to evaluate each business on its own merit, management and history.
DENNIS: You are an expert, with a good track record, but there are others looking into the same markets. Why do I suspect the “prime” targets would probably offer lower yields because they are in high demand? I would imagine there are always trade-offs between high yield, but risky versus lower yield offering a greater margin of safety.
TIM: The law of supply and demand for quality investments certainly applies and has an impact on yield. For my Dividend Hunter subscribers, I separate the recommendations list into more conservative dividend stocks, and higher yield, more aggressive stocks. My life would be easier if I stayed away from the high yield ones, but I do love the category and the challenges. Nonetheless, I try to make sure my readers understand the difference with stocks in each group.
A very high yield indicates the stock market expects a dividend reduction. The interesting part is that a dividend cut is a binary event. Either it will happen, or it doesn’t. I review all aspects of the business operations of a high yield stock to produce my opinion of future dividend prospects. Great returns can be earned on high-yield stocks when the dividend is sustained.
Sometimes I miss with my analysis. There are always unknown factors. I have also helped my subscribers to get into a lot of winning high-yield stocks.
I constantly remind subscribers to build portfolios with a balance of risk, and not dive too deep into the very high yield swimming pool.
DENNIS: On behalf of our readers thank you for taking your time for our education.
TIM: My pleasure Dennis, glad to help.
Dennis here. With the stock market taking a wild ride, and interest rates sinking to new lows, finding safe ways to invest and earn some quality yield is becoming an ever-greater challenge.
Tim is one of the most knowledgeable people I know when it comes to REITs. Not only can he find the good ones but he educates readers about bad ones, especially in times like these when interest rates come under pressure. What may look good on the surface may be bad and vice versa. We need to understand what is behind the curtain.
As you can see, Tim’s also a teacher. Tim pulls back the curtain and explains concepts, that can sometimes be complicated finance jargon, in everyday, understandable terminology. His readers are informed investors.
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On The Lighter Side
Four generations gathered at our home last week for spring break and to celebrate my 80th birthday, a bit early. While a good time was had by all, it was certainly overshadowed by the non-stop media hysteria over the virus and stock market gyrations.
Seven family members flew back to Atlanta. There were less than 20 people on the plane. When they landed, with voice choked and tears flowing, the flight attendant thanked them for flying. My daughter reports many passengers were in tears as they got off the plane.
The highlight of the flight was my five-year-old great-grandson sat in the pilot seat and got a set of wings. That is something he will never forget. I remember when that was common procedure.
They had a skycap meet the plane with a wheelchair for my grandson. My daughter described her as a young, African American woman who had moved from New York. As they walked and chatted, she too choked up and asked my daughter, “Why is the media focusing on the negative and the deaths? Why aren’t they telling about the thousands of people who have been cured?”
Unfortunately, media promoted fear and panic improves the ratings; particularly when they can use it for political purposes.
It is time for us as a nation and the world to set the BS politics aside and work together to solve the problem. If the crap that has gone on over the last few weeks doesn’t move our country to force congressional term limits, I don’t know what will.
My guess is we could all use some chuckles. Friend Bob O. sent over a cute story.
Heaven and Hell
A corrupt Senator (many to choose from) was hit by a car and died.
His soul arrives in heaven and is met by St. Peter at the entrance.
“Welcome to heaven,” says St. Peter. “We seldom see a politician around these parts; we’re not sure what to do with you.”
“No problem, just let me in,” says the Senator.
“Well, I’d like to, but I have orders from the higher-ups. What we’ll do is have you spend one day in hell and one in heaven. Then you can choose where to spend eternity. That’s the rules!”
And with that, St. Peter escorts him to the elevator and he goes down, down, down to hell.
The doors open and he finds himself in the middle of a green golf course.
Standing in front of the clubhouse are all his friends and other politicians who had worked with him. Everyone is very happy. They run to greet him, shake his hand, and reminisce about the good times they had while getting rich at the expense of the people.
They played a friendly game of golf and then dine on lobster, caviar and the finest champagne. The devil is a friendly guy having a good time dancing and telling jokes.
The party continues until it is time to go. Everyone gives him a hearty farewell and waves as he enters the elevator. The elevator goes up, up, up and the door reopens in heaven where St. Peter is waiting for him, “Now it’s time to visit heaven…
For the next 24 hours, the Senator joined a group of contented souls moving from cloud to cloud, playing the harp and singing.
When St. Peter returns, he says, “Well, then, you’ve spent a day in hell and another in heaven. Now choose your eternity.”
The Senator reflects for a minute, “Well, I would never have said it before, I mean heaven has been delightful, but I think I would be better off in hell.”
St. Peter escorts him to the elevator and down he goes…
The doors of the elevator open and he’s in the middle of a barren land covered with waste and garbage. He sees all his friends, dressed in rags, picking up the trash and putting it in black bags as more trash falls to the ground.
The devil comes over to him and puts his arm around his shoulders.
“I don’t understand,” stammers the Senator. “Yesterday I was here and there was a golf course and clubhouse, and we ate lobster and caviar, drank champagne, and danced and had a great time. Now there’s just a wasteland full of garbage and my friends look miserable. What happened?”
The devil smiles and says, “Yesterday we were campaigning, today, you voted!”
Until next time…
“Economic independence is the foundation of the only sort of freedom worth a damn.” – H. L. Mencken
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