The Ground Up: Always Diversify

The Ground Up is a weekly column written by Brad Thomas on Forbes.com. In the commentary he provides readers with risk assessment concepts in order to assist and prepare investors for the time in which risk meets adversity. As Howard Marks wrote, “outstanding investors are distinguished at least as much for their ability to control risk as they are for generating return.”

Most investors are familiar with the saying - "don't put all your eggs in one basket." And, this risk control analogy also applies to REIT investing.

To minimize risk within the REIT sector it’s important to pay close attention to the sources of revenue that the company generates, especially today since there are a growing number of one-and-two tenant REITs that are entering the public sector.

This principle – not putting all of your eggs in one basket – also applies to my investing philosophy. I would never recommend owning just one REIT and I often advise investors to own at least five or six REITs so that you have a healthy number of eggs in your basket.

Today I’m calling attention to some riskier REITs that do not enjoy sound diversification attributes. Accordingly, these companies have become higher risk alternatives because of their over-weighted tenant concentration levels.

Before I get started, I want to remind you that I’m not steering you away from all of these companies. I actually own several of them, but I consider the risks to be overblown and worthy of ownership, based upon my risk tolerance level.

But every investor should examine his or her own risk profile and always keep in mind that it only takes one torpedo to sink a ship.

The first company that I would like to bring to your attention is CorEnergy (CORR). I own CORR in my small-cap portfolio and I have written about the name in previous article on Forbes.com (here). This REIT is an unusual enterprise since it owns real estate assets that are not your typical meat and potatoes. What I mean is that CORR owns energy infrastructure assets, typical to what you would see in an MLP operation; yet CORR is structured as a REIT.

The biggest egg in CORR’s basket is pipeline called Grand Isle Gathering System, 153 miles of undersea pipeline and storage transportation located in the Gulf of Mexico. CORR paid around $259 million for the asset that generates around $40 million per year, or 37% of CORR’s overall revenue.

The problem with this deal is that EXII is not a credit tenant, in fact, the company is financially strapped and is considered junk-rated credit. Should EXXI cease paying rent, there could be a short-term impact to CORR’s earnings; however, CORR has said that the Grand Isle property is an essential pipeline that is critical to the oil and gas operations.

CORR is trading at $4.69 with a dividend yield of 11.5%. The market is telling us that this security is higher risk; however, there appear to be opportunistic upside given the high discount being offered. Of course, Mr. Market is also telling us that CORR has one big egg (Grand Isle Gathering System) in its basket.

Spirit Realty (SRC) is another REIT with a disturbing egg in the basket.

A few months back SRC acquired a portfolio of free-standing stores leased to the West Coast grocer, Haggen Food & Pharmacy. SRC purchased 20 locations for $225 million at an initial cap rate of 7.5%. Haggen became SRC’s fourth largest tenant, based on revenue, with around 2.6% exposure.

That’s not an alarming level of exposure; however, Haggen recently announced it was filing bankruptcy, just a few months after SRC’s purchase. That’s troubling since SRC has only been a landlord to Haggen for a few months and now management at SRC will be forced to find an alternate tenant to lease or sale the buildings.

Given the more recent news surrounding Haggen, SRC shares have declined and are now priced in at $9.54 with a dividend yield of 7.1%. I consider the dividend safe and the correction appears opportunistic given the low multiple (11.4x) assigned to the shares. I have placed a HOLD on this REIT however, based primarily on the questionable acquisition related to Haggen.

HCP Inc. (HCP) is another REIT with an outsized egg. Specifically, HCP is a large landlord to assisted living operator, HCR ManorCare. Currently HCP has around 25% exposure to HCR and although that exposure to one tenant is not terribly alarming, the real threat is that HCR is under a Dept. of Justice investigation.

The assisted living sector appears to be one of the riskiest real estate categories given the meaningful impact to governmental regulation. While operator cuts don’t directly impact the REIT, the operators could become stressed making it harder for the tenants to pay their bills (of which rent is one).

ManorCare was charged with submitting false Medicare claims for services that, according to the DOJ, should not have been reimbursed because they were either not covered by the skilled nursing benefit or were not medically necessary.

This has served as a major drag on HCP's stock, but the company has taken quick and aggressive action to prepare for any financial penalties as well as reduce its dependency on ManorCare. Shares in HCP are now trading at $38.56 with a dividend yield of 5.9%.

In a few months Darden Restaurants (DRI) will spin-off 430 restaurant properties in a REIT called Four Corners Property Trust. The transaction should benefit Darden as it will lower the company’s debt while also creating a more tax efficient mechanism to unlock equity in its real estate.

Remember that the new REIT will have all of its eggs in one basket. Simply put, there are risks to owning a REIT that derives 100% of their income from one tenant. As I have summarized in this article, CORR, SRC, and HCP are all trading at lower multiples and none of these companies has 100% tenant concentration levels.

So whether it’s a REIT or an Investor, it’s always important to maintain adequate diversification, after all, that’s the simplest and cheapest way to obtain a margin of safety. We all know that it took all of the King’s horses and all of the King’s men to put Humpty Dumpty together again. Remember to keep plenty of eggs in the basket and ALWAYS protect your nest eggs at ALL costs – that’s a good recipe for sleeping well at night.

The author owns shares in CORR, HCP, and SRC.

Brad Thomas is the Editor of the Forbes Real Estate Investor and writes for Forbes.com and Seeking Alpha. He is also a frequent guest on Fox Business and he is currently writing a book, Trump: It’s ALL Business, about U.S. presidential candidate Donald J. Trump.