Leave it to the New York Times to stir up controversy in a topic so universally misunderstood and ignored as economics. A brilliant economist, Robert Shiller, took the opportunity to write for the New York Times and used it to make himself look downright silly. It was a shame, because I'm sure he is an intelligent man. Unfortunately, the way the piece was put together leads to a simple conclusion:
Don't Buy Real Estate. The Dividends are Trash.
This conclusion is clearly supported by his arguments, but it isn't supported by the facts.
The time period used in this analysis is from 1915 to 2015. That seems arbitrary, but I see nothing inherently wrong with using it as a sample size. During this time the real value of farmland increased at a rate of 1.1% per year. The Home Price Index, a tool he helped to create, showed an annual compounding rate of only .6% per year. Of course, these values are all stated on "real" terms, which means they were adjusted for inflation as measured by the CPI (Consumer Price Index).
Those statements should be factually accurate, but they are incomplete.
There is no reference to collecting rent or dividends in the article.
Buying a house for capital appreciation, or an equity REIT for capital appreciation, is akin to throwing the dividends in the trash. His entire argument was based on the premise of price movements. It is perfectly fair to say that land has only appreciated modestly faster than inflation. However, it still appreciated faster than inflation. That is materially more than investors can say about TIPS (Treasury Inflation Protected Securities), which offer negative real yields. I'm not suggesting that returning .6% to 1.1% above inflation is great, but it is worth noticing that simply beating inflation is a valuable achievement.
While Robert Shiller argued specifically about buying a house, condominiums and apartments should fall into the same category. If an investor were to buy his apartments through a publicly traded REIT, he would be able to trade on commissions around 8.95% rather than paying a percentage of the total property value. He could also sell in the span of a minute, rather than months. He could diversify his investment and automatically have the properties managed for him.
The funny thing about Robert Shiller's argument is that it ignored the value of living inside the house. While I live inside my house, I also own shares in a few REITs. As you should be able to guess, I don't live in their properties. Instead, they rent the properties out. In exchange, they receive money. I know, this is a brilliant concept. The money is used to cover overhead expenses and to send shareholders a dividend. If my investment in a REIT amounted only to the capital appreciation of the real estate, then it would imply that I was not getting the dividend. Since the REIT sends the dividend consistently, I would need to have the dividends sent by mail and then manually throw them in the trash. If I simply allow the dividends to be deposited to my brokerage account, I would accidentally expect returns vastly above the .6% to 1.1% Mr. Shiller references.
Even as he focuses in on single family houses, it would still be akin to buying the property and choosing to neither live in it nor rent it out. I must agree with Robert Shiller on this case. Buying property and leaving it vacant, or buying a REIT and throwing your dividends in the trash, would be a very poor investment.
Total Return Expectations
If we remove all debt leverage from a REIT, it would still be reasonable to expect rent to return between 4% and 6% on equity. The normal capitalization rates can run anywhere from about 3.5% to 9%. This does not take into account the growth of the initial investment keeping pace with inflation. This is simply measuring the current income. Since rates under 4% are usually constrained to high population centers with massive restrictions against new growth, many REITs will include some higher yield properties.
After adjusting for the costs of running the REIT, I would expect around a 4% to 6% return. Since the REITs can still claim a tax deduction for depreciation expense (on an appreciating asset), they usually pay out less than the entire value of FFO (funds from operations). They reinvest part of that money so they can acquire additional properties. Therefore, the dividend is usually less than the maximum the REIT could afford.
If Mr. Shiller incorporated even a 4% yield into his calculations, his range would have been a real return at a rate of 4.6% to 5.1%. Beating inflation by 4.6% to 5.1% would be pretty solid.
Inflation Was Not Normal
If investors have read Capital in the Twenty First Century by Thomas Piketty, they will know that inflation prior to World War 1 was virtually non-existent in most cases. Following the war, inflation became a useful way to decrease the real value of government debts so that the principal on the bonds would be reduced in real terms to offset part of the interest payments.
They would also know that the real return on capital (granted before taxes) usually ran around 5%. The real return was simply measured as the amount of income generated by businesses relative their market capitalization combined with the interest income on bonds. This would be akin to using EBITDA/EV across an entire country and across multiple centuries.
Consequently, it would seem that earning something in the ball park of 5% before taxes and while keeping up with inflation (which only existed in this manner for the last century), is a fairly normal return on investment.
What Investors Should Do
Investors should look for intelligent ways to invest their capital. Buying a house is one perfectly reasonable option, so long as the investor will either live in it or rent it out near market rates. Suggesting that homes or real estate is a terrible investment on the lack of price appreciation is simply ignoring the value of the income generated in each year. If the same logic was applied to bonds (throw the interest in the garbage), it would routinely produce negative real returns since any inflation would reduce the ending value.
It wouldn't be a bad idea to learn about investments either. For investors that want the easy option, use the Vanguard REIT Index ETF (NYSEARCA:VNQ). The highly diversified fund offers a respectable yield of 3.82%. I should emphasize that the yield should either be reinvested in shares, used to buy other shares, or used to support your lifestyle. Do not buy these shares and then throw the dividend in the trash!
Investors that want to go deeper can learn how to analyze high quality REITs like Realty Income Corporation (NYSE:O), National Retail Properties (NYSE:NNN), STORE Capital (NYSE:STOR), or EPR Properties (NYSE:EPR).
If they want more safety, they can look at preferred shares trading around par value and offering some call protection. For instance, Annaly Capital Management (NYSE:NLY) has the E series of preferred stock. Prior to the most recent price appreciation, it was offering a yield of almost 7.5%.
If investors want to go even deeper, they can learn more about how to analyze the common stock. The common stock on a mortgage REIT like Annaly Capital Management is fairly volatile, but it offers a yield over 10%. Since the share price is likely to decline over time, I should emphasize that the dividends must be used or saved. They should never be thrown out. That message is coming through, right?
Want to Know More About Mortgage REITs and Preferred Shares?
Since the Mortgage REIT Forum is a new exclusive research platform, the first 100 subscribers will be able to lock in their subscription rates at only $240/year. My investment ideas emphasize finding undervalued mortgage REITs, triple net lease REITs, and preferred shares. With the market at relatively high levels, there is also significant work on finding which securities are overvalued to protect investors from losing a chunk of their portfolio.
Disclosure: I am/we are long VNQ, NNN, STOR, EPR-E.
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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