The REIT sector is hot again! Since the start of the year, REITs (VNQ) have returned 29% on average – over 500 basis point more than the broader equity market (SPY):
Moreover, this is only the average performance which includes some undervalued, some fairly valued, and some overvalued REITs. Many of our top picks at High Yield Landlord that were deeply undervalued have far outpaced the average return of the sector during this same time frame:
Professional investors are rushing back to the sector and with “billions and billions” chasing a limited number of shares – prices of REITs have had to adjust upward. But the more interesting question is:
Why are Pros getting back to REITs in 2019?
We think that there are three main reasons to that:
- Slowing Growth, Declining Interest Rates
- The Highest “Safe” Income there is
- Inflation Fears Back on the Rise
I am myself considered to be one of those “professional investors” and I am heavily invested in REITs at this present moment. These three reasons are driving my relative bullishness for REITs as compared to most other market sectors.
I am not alone. Over the next 10 years, institutional capital in the “real asset” space (includes REITs) is expected to nearly double!
Up to $50 Trillion (yes, that’s with a “t”) is expected to rush towards REITs and other real asset investments over the coming 10 years.
Below we discuss why this is happening and why you should follow the money.
#1 Rush to REITs: Slowing Growth, Declining Interest Rates
REITs were hated for most of 2016, 2017 and 2018. Rising interest rates caused a lot of concerns to investors and REITs repeatedly sold off with each rate hike announcement. In 3 years, the REIT market barely moved, and then finally, in early 2019, the momentum returned as the Fed softened its view on rates.
The market is now finally awakening to the fact that interest rates are peaking and global growth is slowing down. What better than REITs and real estate to provide solid results in such environment?
- Peaking Interest Rates: REITs have suffered from great market pessimism due to fears of rising interest rates. Now that these fears are slowly disappearing, the headline risk is removed, and investors are rushing back to REITs.
- Slowing Global Growth: Moreover, now that growth is slowing down in a late cycle economy, investors are becoming increasingly interested in more defensive stocks with consistent income. This includes REITs.
As a result of these two themes, REITs went from:
“avoid at all cost due to rising interest rates”
“buy for defensive income in a low growth environment”
REITs have now recovered by over 25% – but considering that they barely budged for 3 years prior to that – we believe that valuations remain quite reasonable.
#2 Rush to REITs: The Highest “Safe” Income There is
There is nothing more desirable than high and safe income in a yield-less world. As I write this, the 10-year treasury stands at just around 1.8%.
In comparison, REITs yield 4% on average; and many lesser-known small cap peers yield 6 to 8% with perfectly safe payout ratios. In fact, the payout ratios are currently at historically low levels and balance sheets are stronger than ever before in the REIT sector.
The average payout ratio is at ~70% – and cash flow is secured for many years to come through long lease terms. This cash flow is also growing through rent increases and the reinvestment of the retained income.
For this yield level, I am not aware of any other sector with the same level of safety.
MLPs are opportunistic but also riskier due to exposure to commodity prices. BDCs are more cyclical. And regular C-Corps that pay so much, will generally suffer from major challenges.
As such, REITs remain one of the only sectors with high and safe income in 2019.
#3 Rush to REITs: Inflation Fears Back on the Rise
In the near term it is safer and less volatile to hold on to cash; but it also comes at a steep cost in the long run.
One dollar in 1913 is the equivalent of over $25 dollar today. And believe it or not, that is not so bad when compared to many other countries. Consider that the German population lost all its savings two times in the past ~100 years. All the money you had worked so hard to get was worth literally nothing overnight.
With the printing presses going wild all around the world and central banks experimenting new untested policies, it is increasingly risky to hold non-inflation protected assets
Holding cash and bonds as part of an overall portfolio strategy is essential; but the risks of accelerating inflation is substantial.
Professionals recognize that REITs provide bond-like income but also natural protection against inflation since they are backed by real tangible assets. Real estate rents and values tend to increase with inflation. In fact, most leases are today directly tied to an inflation index and rent increases can be automatically enforced. This supports a REIT’s dividend growth and provides a reliable stream of income even during inflationary periods. Research from NAREIT demonstrates that REIT dividend growth has outpaced inflation as measured by the Consumer Price Index in all but two of the last twenty years.
REITs in November 2019: Sell, Buy or Hold?
The answer is that it really depends. Many REITs have become overvalued, but there still exists some niches where value is abundant. If you are a passive investor looking to invest in a broadly diversified index (VNQ; IYR), I would say that quite frankly you are late to the party.
Valued at ~20x FFO on average, it is hard to make a strong case for REIT ETFs, which are overweighted by large caps trading at significant premiums to NAV. There may still be an opportunity to earn market-beating returns, but that is only because the rest of the market is even more overvalued. We would stay clear of passive indexes.
With that said, individual opportunities remain abundant, especially in the more obscure and less crowded sub-segments of the REIT market. Now is time to be very selective and recognize that “not all REITs are created equal.” This is why we reject 10 investments for every one that we make (on average):
Some of our top ideas at present that reflect our broad diversification include Brookfield Property REIT (BPR), Spirit Realty Capital (SRC), and EPR Properties (EPR). Each of them pay higher income than REIT indexes (5-7% yield), grow at a faster or similar rate, and have greater FFO multiple expansion potential. It is by targeting this type of situations that we aim to outperform the VNQ ETF.
Our Core Portfolio currently has a 7.75% dividend yield with a comparable 69% payout ratio despite a yield that’s almost double the index. Beyond the dividends, the core holdings are trading substantially below intrinsic value at just 9.5x FFO – providing both margin of safety and capital appreciation potential (REITs trade on average at over 18x FFO).
Closing Notes: Real Estate and REIT Investing Are Wonderful — if you know what you are doing
In a recent survey, 97 percent of investors indicated that they intend to increase capital allocation to real estate in the next 18 months. When you consider what we presented in this article, this is not really surprising.
Nonetheless, it is important that you know what you are doing. To demonstrate this, consider that the average investor generated only 2.6% annual returns over the past 20 years:
In comparison, passive REIT indexes returned 12.5% per year and outperformed almost all other asset classes:
Then taking it one step further, active and more entrepreneurial REIT investors who target market inefficiencies have managed to reach up to +22% annual returns over the same time period:
This is what we aim to do by specializing in REIT investing. Our objective is to maximize performance by following an active approach to REIT investing with a special focus on value and high yielding opportunities.
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Author: Jussi Askola
Source: Seeking Alpha: Why Top Investors ‘Load Up’ On REITs In 2019