November 24, 2020

Why REITs Are So Durable

7 min read
Investors today are facing extreme financial uncertainty. On one hand, the stock market (SPY) is...

Investors today are facing extreme financial uncertainty.

On one hand, the stock market (SPY) is sitting at a near all-time high and valued at a historically high valuation even as we face a severe crisis.

And on the other hand, interest rates have dropped to 0%, pushing investors out of fixed-income investments.

With the odds stacked against stock and bond investors, what’s one to do?

Data by YCharts

In uncertain times like these, we like to remind our ourselves of a quote from Benjamin Graham, the father of value investing:

“An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” – Benjamin Graham

That means that it should be fairly simple to determine a reasonable estimate of fair value for an investment and its current price should promise a satisfactory return. Anything else should be considered speculation.

At this time, it appears to us that most stocks and bonds fail to meet these simple requirements. Therefore, they cannot be considered to be investments. Or at the very least, they have a certain speculative nature to them.

Real estate, on the other hand, continues to offer durable value and strong future return potential. In the rest of this article, we will discuss why we invest heavily in real estate (and REITs) and why you may want to do so too.

The Great Durability of Real Estate

Real estate is the epitome of Graham’s definition of an investment. It’s a piece of the planet that combines land with man-made improvements. Therefore, it’s tangible, and it provides clear value to its occupier and its owner.

Real estate investments have existed for centuries and gone through many severe crises, which include world wars, pandemics, terrorist attacks, and monetary crises, to name a few. Yet, high-quality properties that were conservatively financed and well-managed always have survived and bounced back.

A great example of that is the old town of Tallinn in Estonia, which is one of the hottest real estate markets in Europe and one of the best-preserved medieval towns in the world. Most properties were built between the 13th and 16th centuries. They are 100s of years old and have gone through many severe crises.

Yet, these properties are today more valuable than ever before:

How to Spend 24 Hours in Tallinn, Estonia

source

Businesses come and go. Bonds come and go. Currencies come and go. But real estate is here to stay.

What makes real estate so incredibly durable?

There are three key reasons:

First off, it’s absolutely necessary for the survival and prosperity of the human race. Everyone needs shelter to live. Farmland to grow food. Warehouses to store goods, etc. Technology may change how we use real estate over time, but it cannot remove the need for real estate.

Secondly, it’s strictly limited. The amount of land and resources to build properties is finite. Moreover, certain locations are clearly more desirable than others and this restricts the amount of available land even further. As an example, farming food in the Sahara Desert may not be practical. And living alone far from social communities isn’t desirable to most people.

Thirdly and finally, real estate is flexible. Most of the value is in the land and the structural improvements can generally be adapted over time to its best economic use. As an example, just because a property serves as an office right now doesn’t mean that it won’t be converted into high-end apartments 20 years from now.

Because real estate is necessary, limited and flexible, its value is remarkably durable and stable.

This durability is put on a whole new level when combined with the REIT structure, and this is what we will discuss next.

The Even Greater Durability of REITs

REITs (VNQ) are large investment firms that specialize in income-producing real estate investments. They collect capital from a large group of investors and then invest the proceeds into real estate.

What makes REITs even more durable than private real estate investments?

There are three key reasons:

First off, REITs are very well diversified. The biggest risk in real estate investing is if you own only one or a few properties and you then run into some issues. REITs often own 100s, if not 1000s, of properties. As such, if one property performs poorly for a reason or another, it does not greatly matter in the grand scheme of things.

Secondly, REITs are professionally managed. Being a landlord is work intensive, and if done poorly, the operations can quickly deteriorate. The tenants need to be happy. The property needs to be maintained. And deals must be made at appropriate prices. REITs attract the best talent in the real estate world.

Thirdly, REITs are conservatively financed. REITs use only 30%-40% leverage in most cases, and this is very conservative in the real estate world. In comparison, most private real estate investors use closer to 60%-80% leverage.

Because most REITs are well-diversified, professionally-managed, and conservatively-financed, their value is remarkably durable and stable.

That’s at least true in theory, but in practice, REITs can be highly volatile because they are traded on the stock market.

In an interesting way, the liquidity of the stock market can become the curse of REITs because it gives investors a false sense of elevated risk, when in reality, the business model of REITs is highly resilient.

At times, it results in very attractive investment opportunities when the durability of REITs becomes underappreciated. Recently, the REIT market crashed due to COVID-19 fears, and we believe that now is a great time to invest in this resilient sector.

The Case for Investing in REITs Today

Stocks and bonds appear to be overpriced and risky at this moment. Therefore, they may not offer satisfactory future returns and would be characterized as speculation by Benjamin Graham.

In comparison, REITs are very opportunistic. They have recently become deeply undervalued because their durability is underestimated and their risk profile is misinterpreted.

REITs are today feared because many believe that the COVID-19 crisis will lead to a significant deterioration in future prospects for real estate investments. This belief is based on several misconceptions, which include the following:

“Malls and office buildings are dead.”

“REITs cannot collect rents.”

“REITs are overleveraged.”

In reality, 90% of REITs do not invest in malls or office buildings. Instead, they invest in highly-resilient properties such as apartment communities, industrial facilities, grocery stores, farmland, etc.

Moreover, the great majority of REITs have kept enjoying near-100% rent collection rates throughout this crisis. Only retail REITs have struggled.

And finally, REIT balance sheets are today the strongest they have ever been. They are not overleveraged. Opposite of that, many of them are underleveraged, which will lead to faster growth in the coming years.

Nonetheless, because of these misconceptions, REITs are today priced at near their lowest valuations in 10 years based on yield spreads:

Many high-quality REITs now yield more than 6% even as the 10-year Treasury has dropped to just 0.8%. That yield spread is unprecedented.

A great example of that is W.P Carey (WPC). It’s a strong investment-grade rated REIT with low leverage, long leases, and mostly industrial properties. It’s not greatly affected by the crisis. In fact, it has kept increasing its dividend. Yet, you can buy it today at a 6.4% dividend yield. That’s a dividend that has been hiked for 22 years in a row – highlighting the resilience of WPC:

source

At High Yield Landlord, we think that such companies are deeply undervalued because of a temporary crisis that won’t heavily impact their long-term prospects.

As the fears start to dissipate, we expect WPC-type REITs to reprice at closer to a 3%-4% dividend yield, which would still be very significant in a 0% interest rate world.

Assuming that WPC repriced at a 4% dividend yield, that would result in 50% upside from the current share price, and at a 3% dividend yield, it would need to more than double from here.

Repricing at 4% Yield Repricing at 3% Yield
Upside Potential 50% 100%

WPC is not an exception. It’s just an example among many others. Such REITs offer high income coupled with significant upside and strong resilience.

I don’t know about you, but this truly feels like an investment that would fulfill Graham’s requirements. We would even go a step further and say that such REITs are the epitome of Graham’s definition of an investment.

Closing Notes

REITs have existed for more than 50 years and they have gone through many severe crises. Yet, they always have fully recovered and kept outperforming the rest of the market over multi-decade time periods:

Buying REITs during times of crisis always has been a winning strategy in the past, and with interest rates at 0% today, we believe that it is only a question of time before REITs return to new all-time highs.

Yield-starved investors need income and the current yield spreads are at a 10-year high. At High Yield Landlord, we have cherry-picked the 25 best REIT opportunities for our Core Portfolio to maximize gains in the coming years.

While we cannot predict short term results, we believe that long-term oriented investors who understand the durability of REITs will be richly rewarded.

Opportunities are Abundant! Act Now!

Here at High Yield Landlord, we are loading up on deeply discounted real estate at the moment. Opportunities are abundant and now is time to act while the market is volatile!

We are sharing all our Top Ideas with our 2,000+ members. And you can get access to all of them for free with our 2-week free trial!

You will get instant access to our 3 Model Portfolios, Course to REIT investing, Tracking tools, and much more.

We are offering a Limited-Time 27% discount for new members!

Disclosure: I am/we are long WPC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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