Friday, January 8, 2016

A Change of heart on REITs and MLPs

My goal as an investor is to generate a sustainable stream of dividends, which will pay for my expenses in retirement. I need this income stream to be as secure as it can be, in order to pay my expenses during recessions, depression, bull markets or bear markets.

My recent experiences with Kinder Morgan got me thinking a little bit about pass through entities in general. I am starting to question whether those dividends are indeed as bulletproof as I once thought they were. It is tough to have a change of heart, especially after enjoying a rising stream of dividends with Kinder Morgan (KMI) and REITs like Realty Income (O) between 2008 and 2015.

After some thoughts, I have come to believe that pass through entities are less reliable than regular corporations during times of distress. And during times of distress you need to have the comfort in knowing that your distribution is secure so that you can hold on to your stocks. If we are in a recession, and a company decides to cut dividends, we are in for a double whammy – lower dividend income along with lower value of the investment. I want durable dividends, no matter what happens stock market or economy. I want to receive dividends throughout the stock market or economic cycle.


I have been either lucky or a good stock picker, because a good portion of my pass-through entities have done very well in the past 7 -8 years. However, my experiences with Vereit (VRE) and Kinder Morgan (KMI) are showing me that perhaps I was more lucky than I would care to admit.

I think that over time, I started letting riskier companies in my portfolio, and I may have started chasing yield. Losing  some discipline is not a good trait to have. Chasing yield is another trait to avoid. Perhaps, if I don't see enough quality selling at good prices, I should not be decreasing my quality requirements and just allocating my cash left and right.

I realize that when a company needs to continuously sell bonds or stocks to grow, and pays all of its free cash flow to shareholders, it could get in a dangerous position. When you ask for the kindness of strangers when the financial markets seem to be falling apart, you are asking for trouble. When you don’t have a lot of flexibility, your company might have to decide between continuing as a going concern or cutting dividends. Of course, in this situation of distress, the dividend is the thing that will go away. It doesn’t matter if the portfolio of assets is stable and generates recurring cashflows that are relatively dependable – when you invest for the long-term, but continuously depend on the short-term mood of Mr Market to obtain capital, you are exposing yourself to excess risks.

The other issue is if you have a manager on top, who is really an empire builder. I am afraid that a lot of projects that were financed in the past two years in real estate and energy might have only been done because the cost of capital was really low. When you have the pressure to allocate capital, you are drowning in cash, and your competitors are having a similar pressure, the potential for return on investment is decreasing.

The more I think about it, the more I realize that I am more comfortable with stable companies like Diageo (DEO) or Johnson & Johnson (JNJ). These companies generate enough in earnings to cover their dividends even if those earnings stay flat for several years. There is a built in margin of safety in dividends, that can provide some stability in case of short-term turbulence in earnings and revenues. A company like Kinder Morgan or a REIT have a very limited margin of safety in dividends given the fact that they send almost all of their free cash flows to shareholders/unitholders.

This doesn't mean that those REITs or pipeline companies cannot deliver excellent long-term results. It only means that the dividend income they generate is one step lower in safety, relative to regular corporations such as those in the consumer staples sector. As an investor, my goal is to get dividends that are dependable, so I can live off my portfolio. If a company is too risky to maintain dividends during a recession, then it has no place in my dividend portfolio.

Therefore, when I hold a company like Diageo (DEO), I am more confident holding even if the stock price falls by 50%. In the case of pass-through entities, when the stock price falls by 50% and they need to access capital markets, their free cash flow is squeezed leaving less money for dividends. This increases the chances of a dividend cut.

The action plan as a result of this change of heart is that I will be gradually reducing my exposure to pass-through entities such as REITs and MLPs (or MLP C-Corps). Most of my REITs are close to 52 week highs, while most of the MLP C-Corps are close to 52 week lows. Perhaps this move shows that I have realized I don’t understand as much as I thought before. I had roughly 5% - 6% of portfolio to REITs and little over 2% in MLP C-Corps or MLPs by the end of December 2015.

I slowly began this move in all companies affected early this week, which was unfortunate, because markets were crashing. I will likely be phasing out of those entities, subject to pricing and valuations of course. Since the stock market is a competitive game, I will not be providing more specific information on this topic.

Full Disclosure: Long all companies listed above

Relevant Articles:

How to define risk in dividend paying stocks?
Dividend Investing Risks
Margin of Safety in Dividends
The Humility Dividend Growth Portfolio
Three Investing Lessons I Learned the Hard Way

26 comments:

  1. Some REITs with 25+ years of dividend payments and consistent dividend growth seem to remain dependable life-long investments. I will hold on to ones like Realty Income (O) because their dividend increases are based upon increasing Free Cash Flow and a coverage ratio well above 1.0X. - Jungle Jim, long O.

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  2. To recap, you are feeling that pass through entities are less safe because they have a higher dividend payout ratio to cash flow, and therefore are more likely to cut dividends in distress?

    Looking at the Value Line for Realty Income... I can see why that would be a concern with 94% in 2010. But aren't they one of the safest?

    One thing that bugged me about KMI was getting a handle on what the earnings really were. It feels like some REITs are the same with depreciation expenses that don't reflect reality.

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  3. Seems to me that fundamental analysis applies to all corporate components of an economy, whether healthcare companies, MLPs, transportation companies, REITs, industrial companies, consumer defensive, etc. You stand to gain if you buy at good fundamental valuations and diversify, and adjust as appropriate over time. And if there are no good values, you accumulate cash and wait for the inevitable cycles within sectors and industries to present opportunities.

    You as much as pointed this out when you mentioned that last quarter your REITs were up and your MLPs (and many of your traditional C-corps, I reckon) were down. In itself not an indicator of what you should acquire -- that's still a matter of each company's prospects and valuations -- but I'll bet there were better values with the latter than the former at that time.

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  4. I'm starting to question whether all the extra work of picking stocks is worth it, or maybe I should just dump money into VIG and get on with life. (Long KMI)

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    1. I also like VIG and have realized over the last few years that picking stocks is not my strength. Sure, there is an expense fee of 0.1% but I could pay alot of expenses with disasters like KMI, LINN, EPD, ETP, ext. Don't forget about VYM (higher yielding dividend companies) or VPU (utilities). I still have a few individual stocks and its been fun and educational but as has been said-you have to know your limitations.

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  5. I've wondered about the stability of REITs and MLPs as well. If the Free Cash Flow doesn't cover the dividends and you have to sell more stock or take out a loan to cover, isn't that basically the same thing as a Ponzi scheme?

    I admit I don't understand it since O doesn't cover it's dividends anymore, nor do many other REITs. KMI wasn't covering this year (as I'm a newbie and never invested in KMI, the cash bleed was a big red flag to me...). Lots of BDCs are in the same boat (though PSEC, which many love to hate, appears to be OK now).

    Anyway--thanks for the post. Definitely something to think about before betting my hard earned money!

    P.S. Since I'm new at this, I don't think I'll ever "SWAN"--and instead check at least every quarter to make sure my investment is still OK. All things change....

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  6. This is a very legitimate concern. I fully agree and have been using credit ratings to narrow down stocks. If it is a Reit or Mlp I want a BBB+ or Baa1 or higher rating. Reits like O or NNN that have this rating have so much wiggle room to issue debt and hold off equity if their stock is in the gutter for a year or even longer. The BBB+ means it takes 3 strikes or downgrades to be junk. KMI and VER were BBB- or one notch from junk...that was a warning sign. I owned both and made same mistake..fortunately got out of both early with 15% losses but lesson learned nonetheless.

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  7. Good article, as usual.

    I'm impressed that you review and change your investment strategy as you learn new things and have more experiences. To me, that shows a lot of smarts.

    I'm always reminded of Bill Miller (Legg Mason)who was the smartest guy in the room for many years. He handily beat the returns of the S&P for 17 years in row (or so). His plan worked great, until it didn't and in 2008 he was down 72%. My goal is to imitate that!

    Happy and successful 2016 DGI.

    SAK

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    1. Oops, correction...my goal is to "NOT" imitate the 72% drop!

      SAK

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  8. Interesting, DGI. I have never invested in MLPs, but we do still hold KMI. After the recent KMI debacle, I had a similar epiphany. In my case, I decided to reduce risk by selling all stock in companies with less than a BBB+ S&P credit rating. The only REITs that met this standard are O and VTR, and they make up only 3% of our portfolio, so we will probably keep them and reinvest the dividends. All other REITs were sold at a profit, so at least it wasn't painful to get rid of them. I do not plan on adding any other funds to either REIT, however, nor am I looking for other REITs with a BBB+ credit rating to invest in. My wife and I can accept the risk for 3% of the portfolio, and it does make some sense to have more exposure to real estate than just our house.
    Best wishes for 2016 (and it looks like it could get interesting),
    KeithX

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  9. I concur with some of your concerns. I have always NOT been "comfortable" with the finances of nearly all the MLPS, and have traditionally avoided them. Over the past two years, my wife inherited two MLPS (EPD and ETP) and after looking at them, I felt ETP was "the best financial house in a bad financial neighborhood". I therefore added a small amount to her position. I also added another one (SEP) as it also looked like one of the "strongest" in the neighborhood, financially.
    With REITS, I have also been suspicious of their cash flow and dividend coverage. My approach is to LIMIT the size of these type entities (pass through entities) that are dependent on high and stable cash flows, especially when they ALL fund their "growth" through issuing both debt and more stock. They DO NOT have the "margin of safety" that other "high quality" dividend growths stocks have, like the "Dividend Aristocrats". I also try to pick ones with LONG histories of steady dividend increases (O, NNN, WPC, all stand out- and I own O and WPC). If you limit the overall allocations to say 2-5% of your portfolio, it limits the downside risk in case the economy suffers a downturn, they are unable to pay their dividends, cut them, and their stock prices collapse also. Your total losses are "capped" to a manageable (although still painful) level.
    Win1177 (on morningstar)

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  10. Hi DGI. I eliminated almost all my REIT and MLP exposure during Christmas week after coming to the same realization. However, I have held onto O and HCP for reasons given in the first comment. A long track record and conservative well balanced debt schedule allow me to keep these two. I know HCP has issues with tenant concentration, but again conservative management now in place allows me to continue to hold. I eliminated DLR, OHI, WPC and VTR - all based on credit ratings. All the best in the new year. I've learned a lot from you.

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  11. Isn't KMI now a C-Corp? I also agree I will be reviewing the REIT holdings I have. I avoided MLPs since I didn't understand them nor want the IRS issues with them.

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  12. One option for MLP exposure is an ETN like AMJ.

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  13. DGI-You have to do what you feel comfortable with with respect to your investments. After all it's your money.
    I enjoy your articles. Many happy returns! Philip

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  14. Hey DGI-

    I too have been stung by KMI and VER(ARCP). However, I attribute this to my own shortcomings, not that of all pass-through entities. I think I got greedy and slacked on my own research. I do agree that these entities are slightly riskier. But long term, REITs are a fabulously performing asset class. I think you and I just need to value and research them differently than a C-Corp. For those reasons, I will be holding on to the likes of O, NNN, and DLR.

    -Z

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  15. Been a dividend growth investor for over 15 years now. Have never owned a REIT instead I buy the real thing I buy tangible Real Estate in the form of my principal residence and they investment properties. The purchase of your principal residence should be the first step for most people. Even before you buy your first dividend stock. Real estate provides you with the best tax shelter we have available. All capital gains grow tax free on your principal residence and when sold all funds come to you completely tax free. I caution everyone to always buy real estate with a long term holding period just like we do with our dividend stocks. There will be corrections in the short term with real estate. Buy it live in it enjoy it and you will do fantastic in the long run but buy the tangible product not a REIT. You can't live in a REIT Finally if you are renting you should be taking a close look at the difference between owning long term and the tax advantages and synergies it creates vs renting with our current interest rates you are going to be far better off owning your principal residence.

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  16. I see them as better inflation hedges than common stocks, they aren't something you should overburden a portfolio with, but things like rising rents are good portfolio protection. Understandable position though.

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  17. DGI,

    I agree that pass through entities like MLP's and REITs represent a different set of risks. Although some can be OK. For many investors its probably better off if they buy an ETF covering the sector if they do not understand how to analyze individual companies to help minimize risk. Personally I hold HCP as the only individual REIT in my portfolio and I believe you do as well. Also I am big on DEO right now also. I think the issues with lagging sales and EPS are transient. Im willing to bet in 20 more years there will be more people drinking Guiness and Crown Royal than today. The craft trend is putting a dent in sales for plenty of beer/spirits brands, but well managed companies will learn to adapt and change their gameplan.

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  18. Takes a big man to do a mea culpa such as this on a public forum. Have enjoyed your articles for some time, but never felt the urge to leave comments. But this article has increased my respect for your integrity on an exponential level. Having spent several years in the financial services industry (2 major wirehouses)I have been exposed to all sorts of "best thing since the wheel" ideas. Truth is, if something has been created with a tax advantage being one of the primary drivers to attract money, caveat emptor applies, in a BIG BIG BIG way. Many great fortunes have been made the old fashioned way. Do your own homework, and own quality assets with a long term track record. Live Long and Prosper !!

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  19. I think REITs and MLPs are like any other asset class such as C corps, farmland, real estate, etc. in that they come with tradeoffs and a mix of good (and bad) individual investment choices. We have to pick our spots in every category and if the standard is who will maintain dividends during a recession then I can think of a few REITs and MLPs worth considering such as EPD, MMP, FRT, HCP, and O.

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  20. Hi DGI...love your blog. My favorite financial reading. I'm in the same position. I've got Plains All American in my taxable and Roth accounts for a while now (yeah, mistake). With the recent pipleine mechanical integrity failure in California, I really question their management practices now, apart from the pain all MLP's are having right now. If the distribution/dividend gets cut then I'm selling. If it doesn't I'll probably sell more gradually. Best wishes,

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  21. I think sticking with the stocks that made it through the Great Recession still raising their dividends are the ones to be in. NNN is one of those and I plan to hold them until the numbers tell me otherwise. I treat them no different than the regular corp. shares.

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  22. i will remove all reits from my watchlist and also more risky stocks as i learned in the last 3 years that i have the biggest gains with boring stocks like p&G, Unilever, Coca Cola etc. so i sell all that is high risk and stopo chasing yield that i started last year....

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