Sell alert: 2 REITs are getting risky

I’m very bullish on REITs (VNQ). So much so that I currently invest over 50% of my net worth in this one sector.

They are at their lowest level in over a decade and historically such lows are The valuations generally led to very strong total returns in the following years:

REITs outperform market declines — Janus & Henderson

Therefore, I think REITs offer a unique opportunity to make big gains, and I am positioning my portfolio to maximize those gains in the coming years.

However, that doesn’t mean that all REITs are worth buying.

This is a huge and diverse sector with over 200 companies in the US alone and 1,000 worldwide in over 30 countries.

Just because I am bullish on REITs doesn’t mean I’ll just buy any of them. Here are two examples of REITs I would sell if I owned them today:

SL Green (SLG)

SLG is one of the most popular REITs among retail investors because it has a historically low valuation, pays a dividend yield of nearly 6%, and owns mostly prime office towers in Manhattan:

Homepage – SL Green – NYC’s Largest Commercial Landlord — SL Green

The bulls’ investment thesis is that the market has overreacted to the threat of remote work. Class A office buildings are here to stay, especially those in exceptional locations.

Many investors therefore see this as a temporary crisis that will soon trigger a spectacular recovery, leading to a significant uptrend and earning you a high dividend yield while you wait.

SL Green Lands Tenant in New Trophy Tower – Commercial Property Executive — SL Green

In my opinion, it’s a pretty good investment thesis.

However, it has some shortcomings.

First, it has already risen multiple times, so much of that upside has already been realized. SLG has already gained 150% from its lows while most other REITs have stagnated, and so is relatively less desirable today.

Second, while I agree that Class A office buildings will perform well in the long term, I still think they will face significant short-term problems as the office market is very oversupplied.

The average occupancy rate today is only ~80% – the lowest in over a decade! This means that property owners are competing with each other for tenants, offering large concessions, tenant improvements and rent reductions to avoid vacancies. This is clearly reflected in SLG’s recent results, as the company’s occupancy rate fell below 80% for the first time in a very long time and rents on new leases fell 5.5%.

And unfortunately for SLG, I expect this oversupply cycle to continue for many years to come. Many companies have already moved to a hybrid work environment that requires less office space, but many of these tenants still have long-term leases today that won’t expire for another few years.

In addition, many of the substandard Class B office buildings will likely change hands in the coming years as new owners move in and reinvest heavily in their properties to compete with Class A properties. This, in turn, will force Class A landlords to continue to make large concessions and reinvest in their properties. Taking this into account, SLG’s actual cash flow is likely much lower than it appears today.

One final point about SLG is that it is 100% focused on New York City, which will likely suffer even more than many other office markets. NYC is very expensive, taxes are high, regulations are not particularly business friendly, so if you want to revamp your office space, in some cases you might as well move south or out of the way. However, there is a tremendous amount of supply in NYC and so I fear the supply/demand imbalance could persist for a long time.

At 9x forward cash flow, the stock is not particularly cheap compared to many other safer alternatives in the REIT sector and therefore I have no interest in owning shares of the company.

Host Hotels and Resorts (HST)

HST is the largest hotel REIT in the world and owns some amazing properties. I think the REIT will do pretty well over the long term if it is priced appropriately, has a good balance sheet, and is well positioned to take advantage of potential buying opportunities in the industry if and when things get tougher.

However, this is a sector I want to avoid as it has historically been the worst of all real estate sectors and I don’t expect this to change:

Host Hotels & Resorts are encouraged by temporarily increasing business demand — Hotel and resort hosts

I don’t expect this to change because:

It is highly cyclical, and we are probably closer to the end of this cycle than to the beginning.
The competition is very big.
It requires enormous investments.
Profits are increasingly being eaten up by booking websites.
These websites cause flags to lose value.
Airbnb (ABNB) and others continue to grow rapidly.
Zoom (ZM) reduces business trips.
Some offices will be converted into additional hotels in prime locations.

Home – Host Hotels & Resorts — Host Hotels & Resorts

All of this does not bode well for the hotel industry.

I still expect some players like HST to do relatively well, but why invest in them at an FFO ratio of 9 when you could buy far stronger and safer REITs at comparable valuations?