How To Protect Your Income From Falling Interest Rates – Part 2: Investing In REITs

Co-produced with Beyond Saving and PendragonY for High Dividend Opportunities

How To Protect Your Income From Falling Interest Rates (Part 2: By Investing In REITs)

In a previous article, we argued that an economic slowdown is at risk of turning into a full-blown recession. We believe that the risk of a recession in the next two to three years is extremely high. Therefore, we want to move into a more defensive position with our portfolio, but we do not want to become overly defensive. Equities often rally, and sitting out of the market has an opportunity cost.

In the previous article referred to above and entitled How Can You Protect Your Income From The Next Recession? we stated:

Interest rates have only one way to go in this kind of environment and that’s down. When economic growth slows down, relying on capital gains for income becomes increasingly difficult.

This is where income products come in very handy for investors and retirees.

This is where REITs come in as an ideal part of structuring a portfolio that will have stable income through a recession but will continue to provide upside in an environment where interest rates are headed lower.

2008 was a real estate driven recession, and while many REITs had significant drawdowns and dividend cuts, others proved more resistant. Some REITs even continued increasing their dividend throughout the recession.

Here’s a look at REIT sectors we believe will outperform.

1- Net Lease

Net lease REITs had solid performance through the last recession. While everything experienced a drawdown in price, quality net lease REITs maintained or even increased their dividend.

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Net lease REITs have the benefit of a very simple structure and virtually no required expenses. With “triple-net” leases the vast majority of property level expenses like maintenance, upkeep, and taxes are the responsibility of the tenants.

The beauty of this simplicity is that it can be applied to all sorts of businesses, from restaurants, convenience stores, banks, pharmacies, auto mechanics, fitness clubs and much more can be found in net lease portfolios. This significantly reduces the risks of a particular tenant sector performing poorly.

On the revenue side, the leases tend to be long term, often 10-20 years, with built-in escalators and automatic renewal options. The rent is generally fixed and does not have any variable components. This provides a very predictable rent level for the tenant and the landlord regardless of macro-economic conditions.

When a recession hits, this means that rents and property level expenses both remain stable. The main negative impacts come from tenant defaults, a harder time leasing vacant properties and a lack of acquisition targets.

Net lease REITs tend to be highly diversified across tenants, the properties are attractively located and can often be repurposed or sold to recover the underlying land value if a tenant leaves at the end of the lease.

The bottom line is that the fundamental business of their tenants is usually tied to the buildings they are renting. Net lease REITs further protect themselves by entering into “master lease agreements,” these types of agreements will often span dozens of buildings and the tenant is required to pay rent for all of them, even when they close a location. If the tenant defaults on one location, they default on all of them and risk eviction. Nothing short of bankruptcy is going to create a material risk for the landlord.

During a recession, a REIT might have a higher percentage of tenants leave when a lease expires and have a harder time finding a replacement tenant. To mitigate that risk, net-lease REITs keep a smooth schedule of lease expirations. Typically, net lease REITs only have 5%-10% of gross rental revenue expiring each year.

This structure means that when a recession hits, the REIT can just hunker down and maintain most of their current cash flows, then be ready to start acquiring new properties at the early signs of recovery.

We are currently invested in several of these names in our Preferred Stock Portfolio. Some of the best names in the sector include the old guards: Realty Income (O), WP Carey (WPC) or National Retail (NNN) will definitely be on our radar during a recession because we would love to add at a steep discount, but they are at a premium today. Spirit Realty Capital (SRC) or Vereit (VER) are two great companies that did not exist last recession, but both have strong triple-net portfolios and are trading at attractive prices.

As noted above, we have been recommending to our investors to buy Preferred Stocks within the “Net Lease” space that are rock solid and are issues we want to hold through any recession for safe income.

2- Self Storage

Self-storage REITs also set themselves apart as recession resistant as fundamentals held up through the recession.

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Like net-lease REITs, self-storage benefits from having very low expenses. Often their largest property level expense is property taxes. Self-storage demand has proven to be recession-resistant as people either need self-storage or they don’t. The macro-economic conditions have little to do with it.

The main risks for self-storage are competition and overdevelopment saturating a market. These are issues that can and do occur in both good and bad economic conditions.

Large, diversified public storage REITs are going to provide more stability than smaller, more concentrated storage REITs. Opportunities in the sector are thin right now among common shares, as the sector’s solid reputation has pushed valuations higher. Some of the best names are Jernigan Capital (JCAP), National Storage Affiliates (NSA) and Public Storage (PSA).

In order to maximize cash flow and lower price volatility, we have focused on preferred stock investments in this sector like Jernigan Capital (JCAP.PB) which we recently wrote about in an article right here on Seeking Alpha entitled:

A Durable 7% Yield Preferred Stock From Jernigan Capital That Goes Ex-Dividend Soon

There are several other rock solid preferred stocks such as JCAP.PB that conservative investors and retirees will want to consider holding through a recession for a high and safe income.

Residential

Residential REITs were strongly impacted at the beginning of the last recession, but their prices quickly rebounded. People didn’t move just because there was a recession.

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Rent is inherently sticky and very rarely moves down. A recession might cause a slight uptick in delinquencies, but overall, people generally prioritize paying for the roof over their head.

Our favorite residential model is mobile home REITs. Mobile homes have an advantage over apartments in that the landlord is primarily responsible for maintaining the lot as opposed to having to spend on maintaining buildings. This allows the business to be very high margin compared to their apartment peers.

During a recession, mobile homes already are the “cheap” option. That lowers the risk of tenants leaving to downsize. The tenants often own the home, so they have little incentive to leave it. Since rental revenue tends to be very stable, mobile home REITs tend to be extra sensitive to interest rate fluctuations. As interest rates drop, they stand to benefit.

Some of our favorite picks in this field is UMH Properties (UMH) which had a huge run and is a bit expensive now. We also like apartment REIT Bluerock Residential (BRG) and single-family home REIT American Homes 4 Rent (AMH).

Again here, conservative income investors may want to consider preferred stocks issued by residential REITs to maximize the safety of the income and lower price volatility.

Conclusion

Our focus is on looking for investments which will provide a high level of income regardless of whether or not there’s a recession. Since predicting the exact timing of a recession is very difficult, we also want investments that have potential capital gains as well.

The REIT structure provides investors with a selection of companies that can meet those goals. REITs center around cash flow and distributing a substantial portion of that cash flow to investors. As long as a REIT has taxable income, they have to distribute at least 90% of it. Many REITs distribute more than that. This makes REITs less likely to suspend their dividend.

Dividend cuts for common shares can and do happen. As income investors, we look for reliability of the dividend in good and in bad times. Therefore we seek to reduce our exposure to potential dividend cuts by focusing on REIT sectors, and more specifically preferred stocks of REITs, that provide much more stability and a higher safety for the income. The key things we want to look for are stability in revenues and stability in expenses regardless of economic conditions. We recently highlighted to our investors (members of High Dividend Opportunities) 10 preferred stocks with exposure to these sub sectors that conservative investors should buy and hold for the very long term and can be held through a recession for the safety of the income.

Net lease REITs, self-storage REITs, and residential REITs all outperformed the average last recession and their fundamental structures create less volatility in revenues and expenses. We believe all sectors will benefit from falling interest rates and will have stable cash flows through a recession. We have strong exposure to all three sectors in our preferred stock portfolio precisely because they are reliable. As we slowly move to a more defensive position, we will be looking for opportunities to invest in common shares in these sectors at attractive entry points.

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Disclosure: I am/we are long JCAP.PB, BRG.PC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.