Retirement Investment Risks Arising out of the COVID-Driven REIT Struggles

Real estate investment trusts (REITs) are often pitched as ways to invest like the wealthiest Americans: you invest in part of a property portfolio without having to shell out the millions of dollars that a wealthy developer has to in order to bring a single property onto the market.

However, many of these REITs carry their own attendant risks: some of the most common REITs are in the commercial sector, such as retail, office and hospitality spaces. With the advent of wholesale lifestyle changes based on the Covid-19 pandemic, it’s worth considering whether or not they are still the safe, promising investment they once claimed to be.

What Are the Fundamentals of REITS?

REITs allow groups of typically at least 100 people to own stakes in properties together, in order to pool the risk and share in the benefits. While often compared to mutual funds, investment trusts come with several key differences:

1) Many are untraded, or are so-called “public nonlisted” or private REITs. This can lead to difficulties in establishing the proper valuations.

2) The math is different for investors. You may analyze a company’s stock based on EBITDA, or earnings before interest, taxes and depreciation and amortization. A REIT uses funds from operations (FFO), or roughly the profits made by the trust after depreciation and other expenses are factored in.

3) Even FFO needs to be normalized based on the activities of that trust regarding its properties. A one-time sale of an office building will significantly distort the profit margins for a brief period, but not over time.

4) The requirements to establish a REIT do not allow them to retain much profit.

5) The lack of market scrutiny and professional investor review, arising out of the fact that most REITs are not publicly traded, has resulted in significant problems that plague the non-traded REIT industry, ranging from corporate governance shortcomings and conflict of interest issues to inordinately high fees. Simply put, non-traded REITs often get away with tactics that investors in publicly-traded companies would not put up with.

More specifically, REITs are required to pay out at least 90 percent of their taxable net income and at least 75 percent of the assets must be in real estate assets whether they be rental income, management fees or something else. They do not create anything on their own and they are not likely to “diversify” into other services or industries. This is offset by the fact that they are “pass-through” entities that are not taxed before dividends are distributed to investors and they enable people to invest in real estate with far less capital than starting on their own.

Why Valuation of REITs Can Vary So Widely

Each set of properties has its own benefits and drawbacks. CBL Properties held property principally in the Southeast in states like South Carolina and Tennessee, as well as mall properties in suburban Missouri. However, these shopping centers included major retailers that filed for bankruptcy like J.C. Penney’s. What may be more troubling is that Pennsylvania REIT (“PREIT”), one of the largest shopping center owners in the Philadelphia area, also ended up declaring bankruptcy.

There are of course underlying reasons why these businesses may have struggled: PREIT banked on its properties in a city’s downtown developing revenue when there was a pandemic. CBL had ongoing issues in terms of liabilities regarding property management litigation. At the same time, they can help to illustrate that often, Covid-19 is merely a symptom of a larger issue.

As noted above, FFO is based only on the properties under management in an REIT, so a careful investor has to be aware of which way the wind is blowing, not just in terms of consumer behavior, but also in terms of regulations. To mention just one example, in California, the governor has repeatedly issued stay-at-home orders for various counties and other states have similarly introduced temporary bans.

This also solely covers retail REITs. The fact of the matter is that many companies have established generous work-from-home policies to protect their workers. There is little to no guarantee for companies ranging from Silicon Valley stalwarts to mom-and-pop shops that their employees will be back to work any time soon. This ongoing volatility has led to difficulties for REITs especially, as it is getting harder to assess demand based on leasing when companies are not sure if they even need to return everyone to the office.

Hospitality is another sector that has been hit hard by the pandemic, thanks to travel bans and stay-at-home orders alike. Major entertainment companies like Disney have laid off thousands of workers and doors remain shut in nearly every state. REIT investors considering when travel will return to normal need to consider not just the lack of business travel, but even vaccine news.

Will They Bounce Back?

A pandemic like Covid-19 is a truly rare experience. It’s been one century to nearly the year that America last faced a condition so world-changing.

However, the country’s adaptation to the requirements of social distancing is merely the canary in the coal mine compared to real underlying issues that have already been brought about since the advent of e-commerce and telework. These developments have fundamentally shifted the value of REITs, especially ones that are marginal in terms of FFO.

For example, malls and other major retail centers have consistently struggled to compete across a broad category of items compared to major retailers like Amazon and eBay. Even the largest big box outlets like Best Buy and Walmart have struggled to compete with online retail. These are trends that predate the Covid-19 pandemic and are unlikely to change, and as a result REITs that focus on retail space are not only going to be difficult to analyze, but continue to be illiquid and suffer from significant volatility.

How Investors Can Protect Themselves

A common adage for investors is to “buy what you know”, and to choose stocks or REITs that you understand. With the amount of volatility in the underlying conditions, the so-called guarantees of dividends may not be quite as easy to come by and you can risk losing money if you are not careful to look carefully at the properties involved. While all investment carries risk, the pandemic has shown the underlying weaknesses in several sectors. It becomes critical to consider the healthiness of various real estate markets when considering REITs even as the pandemic may soon wind down.

Alan Rosca is a securities attorney with the nationwide plaintiffs law firm Goldman Scarlato & Penny, P.C. and an adjunct professor of securities regulation at Cleveland-Marshall College of Law in Cleveland, Ohio.