If a yield looks too good to be true...it usually is

It’s easy to utter truisms like, “If it looks too good to be true, it probably is” – when other people want to get involved in something foolish.

Not so much when we’re the ones faced with seemingly beautiful nonsense on a silver platter.

I learned that early on when I was developing commercial real estate (CRE) for retailers. And the rule applies just as easily to what I do today as an investment analyst.

Not everything that glitters is gold. You can’t judge a book by its cover. And just because an asset comes with a high initial return doesn’t mean it’s a good purchase.

More often than not, it’s actually an indication that you’re taking on more risk than you should.

That was certainly the case in the early 1990s, when I found a portfolio of roughly 20 freestanding Pic-N-Pay shoe stores for sale throughout the Southeast. The cash flow looked attractive, and it came with an eye-popping capitalization rate of up to 12%.

You have no idea how tempted I was to buy it all up. I wanted those stores so badly. But as I reviewed the details, I kept thinking to myself, “This looks too good to be true.”

Sure enough, it was.

Not long after I walked away from that opportunity, Pic-N-Pay filed for bankruptcy protection. And even after restructuring, it had to close most of its stores.

That high income I was so attracted to would have lasted mere months if I’d acted on it. Then I would have spent years trying to re-lease the vacant buildings or otherwise sell the properties.

It was an excellent example of how eye-popping yields are often the market’s way of indicating eye-popping risks.

Here’s another personal example (also from the 1990s) of how careful we need to be when investing…

It was back when I was still developing stores for Blockbuster Video. And since the video rental business was booming, I signed contracts with Hollywood Video and Movie Gallery as well.

Movie Gallery was an especially attractive story for developers since it focused primarily on smaller markets with limited competition. The freestanding stores I built for that company were generating outstanding cash-on-cash returns.

And this time, I have to admit, I did get caught up in the double-digit-yield drama. That’s how I found myself stuck with several empty shops after Netflix came along and fundamentally altered how people watch movies.

Fortunately for me, those buildings were generic retail structures – the kind I discussed last Thursday in “Don’t buy the tenant; buy the box.” As I wrote there:

As such, I was able to fill my Movie Gallery vacancies without too much hassle. Though the experience still served as an important reminder that it’s not enough to just own good CRE…

Those properties need to generate durable cash flow in order to pay off. A high initial return doesn’t mean much if it’s based on a business that can’t survive the changing times.

Thanks to those experiences with Pic-N-Pay and Movie Gallery, I’m no longer instantly attracted to higher yields. Unless I already know the company – and admire what it does and how it does it – I usually react with skepticism first and foremost.

Don’t get me wrong. Dividend-paying investment opportunities that yield 10% or more do catch my eye still. But not in an “I need me some of that!” kind of way.

What I need is reliability. And overly high yields rarely offer that.

There are exceptions of course. Like I already said, occasions do arise when strong businesses fall under unduly harsh market scrutiny. Their stocks drop as a result of that negative sentiment, and their yields automatically rise higher than normal.

Moreover, anyone here who is a regular reader knows how much I love taking advantage of those temporary moments. (In fact, I’m looking into a company yielding 10.4% right now.)

But I’m just as motivated to warn readers away from the typical type of high yielders: the ones that really are too good to be true. After more than three decades of analyzing investment opportunities of one sort or another, I know that income quality is much more important than income quantity.

If that sounds overly cautious, think about it this way: A 50% loss requires a 100% gain just to break even. So it can take years to recover lost capital.

That’s why I’m so quick to warn subscribers about the dangers of taking on too much risk. You need to protect your principle at all costs.

The income will follow.

It’s not the most popular position to take. Believe me, I know. There’s been more than one time when I’ve been called a fool (and worse) for avoiding high-yield opportunities.

Sometimes it took weeks to prove my caution correct. Sometimes it took months. Every once in a while, it took years.

But the results each time were nonetheless that my money and the money of those who listened to me remained safe. And, in the end, that’s what I care about.

An easy example of this is Gladstone Commercial (GOOD), an industrial- and office-focused real estate investment trust (REIT).

Once upon a time, investors loved its generous monthly dividend. So much so that they had no problem overlooking the REIT’s slower growth profile… tighter dividend coverage… and reliance on external capital.

As such, every time I published a caution against it, they piled on the mockery. Couldn’t I see how much money they were making and I was losing out on by being so skeptical?

Yet a few years after I began publishing my dissenting evaluation, Gladstone admitted it couldn’t keep up with its dividend. Just as I’d alleged, it hadn’t been wise with its money – and so it slashed its payout by 20%.

All of a sudden, my critics went silent.

The same went for mall REITs, a sad story to be sure. If anything, they provide an even more dramatic example of how careful investors need to be.

Long before the pandemic, I was warning readers about companies like Washington Prime Group, Pennsylvania REIT, and CBL Properties (CBL). While others were going gaga over their mouth-watering dividend yields, I couldn’t help but notice how powerful online sales had become.

Mall traffic was declining as a result. Small stores were disappearing at a pronounced rate. And even department chains were suffering.

All of this pointed to the market issuing a warning, not a gift.

Investors today can blame the 2020 shutdowns for all three of those high-yielding REITs filing for bankruptcy. But the truth is that malls were already failing.

The pandemic just sped up the inevitable.

Fortunately for us, our fates don’t need to be set in stone like that. We can choose better for ourselves.

After more than 35 years in commercial real estate, I've learned that protecting principal is the foundation of long-term wealth creation. And it all starts with recognizing one simple truth:

If it looks too good to be true... it probably is.

Happy SWAN investing!

Brad Thomas
Editor, The Wide Moat Daily

In honor of the 250th anniversary of The United States of America’s Declaration of Independence, let’s talk about the real estate investment trusts (REITs) that came out of it.

That’s not a cheap gimmick to get you to watch the latest episode of The Wide Moat Show.

The economic opportunities our Founding Fathers opened when they committed to the self-evident truths “that all men are created equal… endowed by their Creator with certain unalienable Rights” including “Life, Liberty, and the Pursuit of Happiness”…?

They’re widespread and enormous.

So we’re more than happy to point even just a few of them out right here.