REITs: The A Team or the B Team?

Real estate is about location and property quality. Some companies focus only on the best of both and others take on more risk by investing lower down on each. That may add risk, but it can also lead to impressive returns.

Real Estate

Real estate is a complex industry. The saying is location, location, location. And while that’s true, there’s also the question of property quality that has to be considered. A dilapidated building in a great location is probably only worth the property on which it sits. Conversely, a top of the line building (often called a “Class A” property) in a secondary market may not be able to get enough rent to justify its construction costs.

The “A” Game

To avoid having to deal with this, some companies focus only on Class A properties in the most in-demand markets. A good example is industrial real estate investment trust (REIT) PROlogis Inc (NYSE:PLD). The company today is the result of AMB and PROlogis combining their portfolios in 2011.

The company is huge, owning around 3,000 industrial properties around the world. It has more than 4,500 tenants and broad diversification across industries. The bulk of its properties are in what it calls “Global Markets,” such as Los Angeles, Paris, Tokyo, São Paulo, and Shanghai. In fact, management is working to increase the exposure to such markets.

Positioning the company in such high-demand markets is a great business model. Like many other REITs, the company trimmed its distribution during the deep 2007 to 2009 recession. It hasn’t increased it since and yields less than 3%.

A or B?

Clearly, its focus on high quality markets and broad diversification offers investors some degree of safety. It also provides growth potential, particularly the company’s efforts to partner with other firms to expand more rapidly. However, for an asset that is supposed to throw off dividend income, a 3% yield isn’t particularly impressive.

Now consider STAG Industrial Inc (NYSE:STAG). The company is also a REIT, but its focus is on secondary markets in The United States. It also emphasizes Class B properties. It’s much smaller than PROlogis, owning just 180 or so properties. However, it’s yield is north of 5.5%.

The company believes that focusing on secondary markets and lower quality buildings gives it a notable edge. For example, competition for properties is lower overall and that competition is often smaller players. In this, STAG can quickly differentiate itself with tenants and on the acquisition front. The company, which came public in early 2011, has grown aggressively through acquisition.

Being in a secondary market with lower quality properties comes with risks, but a yield that is more than 2.5 percentage points higher than Prologis Inc (NYSE:PLD)’ might be worth it for more adventurous investors. Note, too, that the company has achieved 95% occupancy and renewed nearly 90% of the leases that ended in 2012—in an economy that is recovering slowly from a deep recession.