Real estate investment trusts (REITs) generally own property that they lease out to a collection of tenants. The benefit for investors is that they get access to a portfolio of institutional-level income-producing properties with professional management. There's a small wrinkle here, however, when a company spins off a REIT, and it is something that investors need to watch very carefully. Every so often things can go sideways.
Spreading your bets
For most people, investing in real estate isn't a cost-effective thing to do because the money needed to create a diversified portfolio is too great. And the property types available without access to vast sums of money are pretty limited, too. Those are two of the reasons why REITs were created. Effectively, investors pool their money, hire professional property managers, and create an institutional-level property business.
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Of course, that's a vast simplification. Often a company that owns property wants to raise cash, and the best way to do so is by selling its properties. One way that can be done is to spin off a REIT that turns around and buys the properties. That gives shareholders a tax-free spin-off, and the company gets to raise cash from the property sales. Before you decide that this is a win/win, there's one small issue. In such situations, the new REIT generally has only one tenant.
For example, this is how Four Corners Property Trust (FCPT 0.40%), VICI Properties (VICI 1.18%), and Uniti Group (UNIT 0.19%) all came into existence. And for the most part, they all started out with just a single tenant. Here's the thing: If a REIT has one customer that it is entirely, or almost entirely, reliant on to support its top line, how much leeway does management really have to operate in the best interest of its shareholders? The answer is probably not as much leeway as shareholders think.
Consider if that one tenant demanded rent concessions. Whether or not they are justified in the request, the REIT might be facing a situation where saying no would leave it with an entire portfolio of empty properties. There would be a risk of bankruptcy in such a situation, since the REIT would still have to pay for taxes, utilities, and property maintenance while it was looking for new tenants. Even if it can find tenants quickly, those tenants might demand costly property upgrades before signing a lease. It's a material risk that shouldn't be ignored.
Some examples will help
Four Corners was spun off from Darden Restaurants in late 2015. At that point Darden was its only tenant. Worse, Olive Garden accounted for a huge 75% or so of its leases. From day one, however, the REIT knew it had to diversify. Today, roughly eight years later, Darden is 53% of the portfolio, with Olive Garden down to 40% of the REIT's leases. That's a vast improvement, and the diversification effort, driven largely by property acquisitions, has been going very well, including an effort to spread beyond the restaurant asset type. And yet the exposure to Darden is still a material risk factor for conservative dividend investors to think about.
VICI was spun off from Caesars Entertainment in 2017. Casino properties, which is what VICI owns, are very large. Thus, it started life with just 19 assets, all of which were leased to just one casino operator. That's a lot of concentration risk, but management has been working on it. Today, after buying a REIT peer (and a number of smaller property transactions), the REIT owns 50 properties and has 11 tenants, with Caesars down to just 40% of the rent roll. Yes, there's still a lot of concentration risk, but the REIT is far better positioned now than it was when it started its life around six years ago.
Those are examples of steady progress and highlight that, when things go well, an REIT spin off of this nature can be a worthwhile risk. Indeed, both Four Corners and VICI have rewarded investors with a steady stream of dividend increases as they have diversified their portfolios. But things don't always go quite so smoothly.
In 2015, Sears Holdings spun off Seritage Growth Properties (SRG 0.11%). Now-bankrupt Sears Holdings was basically the only tenant via its Sears and Kmart nameplates. Seritage worked hard to find new tenants, but the big boxes it had to fill needed material upgrades. At first, the process went well, but then things started to get tougher, particularly in 2020 when the coronavirus pandemic upended the retail sector. Today Seritage no longer pays a dividend, and it is basically winding down its business by selling all of the properties it owns. This was not a win for investors, though Sears Holdings was able to raise some much-needed cash back in 2015.
Uniti, which was spun off from Windstream, is another problem child. This REIT owns fiber optic cables, with Windstream accounting for around two-thirds of rent even after nine years as a stand-alone company. Along the way, it has been caught up in the bankruptcy proceeding of its former parent, and right now is eyeing a big lease renewal that is likely to be very contentious. In fact, Windstream, which is now a private company, has been explaining in presentations that it expects rent costs to drop by around two-thirds when the lease is renewed in a few years. If that comes to pass, Uniti will be in a financial pickle, and a dividend cut would be nearly impossible to avoid. This helps explain why Uniti's dividend yield is an eye-catching 19%. For most investors the risk/reward balance probably won't be worth the investment.
Know what you own
Clearly, given the Four Corners and VICI examples, this is not meant to suggest that investors shouldn't buy REITs that have been spun off from companies. But investors need to be certain that they understand the risks that so often accompany such situations, the biggest of which is usually tenant concentration. For investors willing to actively track their investments, such situations can turn out to be desirable, assuming the diversification process goes smoothly. If there's any trouble along the way, however, things can go south pretty quickly.
